Risk.

We’re all familiar with it, we all fear it, but only some of us know how to deal with it. One of the largest differences between experienced and inexperienced investors is in how they think about risk. To the beginner, it’s a monster that could pop up at any moment and take your money, and there’s nothing they can do about it. To the expert, it’s just a part of doing business — something is to be expected, planned for, and dealt with. They’re still in control.

You might be thinking, “Huh? Is it really possible to control risk?” The answer is yes… to a degree. You can control it to the extent that you anticipate and plan for it. Let me explain.

I started college in the middle of the .com boom. Like lots of other nerds (err… kids), I wanted to be a part of it, designing computer programs that would usher mankind into a new technological age. So, I majored in Computer Science, which was at the time part of the College of Engineering at our university. In those introduction to engineering classes, one of the first principles we learned was Murphy’s Law: What can go wrong will go wrong… if given a chance.

What’s it mean?

The best way to explain it is to give an example. When NASA sends a shuttle to the moon, it’s an incredibly complex process with a lot at stake. If anything goes wrong, then the whole crew can die. Unfortunately, it’s impossible for them to build a perfect shuttle, platform, or docking station. There are just too many variables. So, what they do is build the best possible equipment and then develop a plan for what to do when something goes wrong.

Because it inevitably will.

They ask themselves, “What could possibly happen to jeopardize this mission?” Then engineers design a plan for what to do if it happens. So, when they hit that inevitable glitch in their plan, they have an idea of how to respond and what to do. They mitigate risk by expecting things to go wrong and then deciding what to do about them. Not because their pessimists, but because they understand Murphy’s Law: What can go wrong, will go wrong… if you let it.

They just refuse to let it go wrong.

Experienced investors take a similar stance. With all of the economic variables affecting a project, they know something will happen to jeopardize their profits and investment capital. It’s inevitable. Yet, instead of trusting the hand of fate, they build in safety systems to protect the investment from the most common problems. Consciously or unconsciously, they ask questions like:

• What happens if the market tanks and we’re unable to sell it as quickly as planned?
• What happens if improvements take longer than planned?
• What happens if no one wants to pay full price?
• What happens if interest rates rise?
• What happens if a competitor moves into the area?
• What happens if one of the partners in this project passes away?

By planning for those scenarios, they dramatically increase their chances of surviving them. Maybe they won’t make as much money as planned, and maybe they will be upset about it, but in the end, they’ll walk away unscathed because they were ready for problems. And, many times, just a few small adjustments can take care of these problems and put the project back on course.

In this post, I’m going to give you some tips on how to mitigate some of the largest risks. Please pay close attention. These lessons are the result of countless hours of lost sleep, countless dollars of money down the drain, and countless mistakes that could’ve been avoided. By learning about them here, you can hopefully avoid some of the suffering we’ve gone through.

I call them the 4 P’s to avoid Punishment:

Pay for a Solid Contract and Keep Improving It

My father always told me, “Everyone despises contracts in the beginning, but they love them in the end.”

To most people, a contract implies distrust and that you expect dishonesty, and if you’re just getting started with the person, it’s usually uncomfortable negotiating the particulars. But do it anyway. I’ve had to turn to contracts more times than I’d like to admit, and I’ve always wished I spent more time refining them.

Why? The main reason is people forget what they agreed to. They’ll forget when they’re supposed to close, how much they’re supposed to pay, and what they’re supposed to do. So will you. Real estate investments can span months or even years, and it’s just about impossible to remember everything. The only way to make sure both you and the other party remember your commitments is to write it down in a contract.

The second reason is people are occasionally dishonest. Give your average person enough of a reason to break their word, and they’ll do it. For example, if you’re buying a house for 30% below market value and someone else offers them full price, then they’ll probably do everything conceivable to get out of the contract. Thousands or even millions of dollars can be on the line, and when there’s that much money involved, people can momentarily forget their ethics.

When that happens, you can sue them, but only if you have a contract. But it rarely gets that far. If your contract clearly shows how they are in the wrong and they know they’ll lose the lawsuit, most people will back up and make the situation right. Not because they suddenly regain their conscience, but because lawsuits are ugly, painful affairs that everyone wants to avoid. Just threatening one is usually enough.

I learned this the hard way.

For several years, I partnered with a reputable, highly intelligent investor on several large land deals. Everything went fine for about two years, and then we started having problems. It got so stressful that he eventually walked away from everything, putting millions of dollars at risk. Unfortunately, our contract didn’t spell out his obligations and the penalties for not performing. So, he walked away with about $1 million in stock.

I am supposed to be a professional investor, but I still got burned. In this case, we even had a contract, but it wasn’t specific enough. So, that’s the second lesson of this post. Make sure your contract spells out as much as you can possibly think of. Even if you can’t imagine something happening in a million years, put it in the contract. There’s always a chance of hell freezing over.

The best thing to do is pay a high priced, highly knowledgeable attorney to develop a contract for you. Then refine the contract for every deal, making it more thorough and specific every time you use it. Eventually, you’ll have a huge document, but it will save you lots of money and lots of stress. Many of our contracts average 60 pages, and we love every single letter in them.

Pad Your Equity to Allow for Price Drops

Properties rarely sell for what you think they will. It doesn’t matter what the appraisal says, the tax value says, or even what the market indicators say. A property is always worth what someone will pay for it, and buyers almost always think it’s worth less than you do. To avoid getting surprised and potentially losing a lot of money, pad your equity for price drops.

What do I mean? Well, let me illustrate with an example.

Last year, a partner and I bought a house for $950,000. The appraisal said it was worth $1,450,000, and every shred of data that I could find said the appraisal was right. We bought the house, spent about $20,000 fixing it up, and then put it back on the market, expecting to make a huge, fast profit. Then we were both a little surprised when no one would offer above $1.1 million.

This happened for several reasons:

• The house had a history of problems and no one believed it was worth the full appraised value.
• Several of our neighbors had the bright idea of putting their house on the market at the same time. To see several houses for sale above $1 million on the same street made buyers nervous, so they made conservative offers.
• Upper end buyers are savvy, and they pulled up the house online to see we only paid $950,000. No one could tolerate us making that much money.

I expected two of those problems, with the exception of our neighbors putting their houses on the market. So, I never predicted that it would sell for full appraised value. Rather, I subtracted about 10%, thinking we would sell it for about $1,300,000. But buyers disagreed. They thought the house was only worth $1.1 million, and no one was going to budge.

Now, if we’d bought the house for the original listing price of $1.1 million, then we might have lost money on the deal. Except, in my infinite wisdom (ha!), I wasn’t comfortable with only 20% equity and negotiated the seller down to $950,000. At the time, everyone thought it was a killer deal, but in retrospect, we bought it with just enough equity to make a little money.

The lesson of the story is you need to build enough equity into the deal to allow for price drops. It’s happened on just about every project I’ve worked on, from apartment complexes to raw land deals. Buyers want to believe they’re getting a good deal on whatever you’re selling, and unless you’re in a hyper competitive market, they’re going to offer less than you think it’s worth.

So, make sure you have enough “wiggle room” to accept. Otherwise, you could end up losing money.

Put Aside More Money Than You Think You’ll Need

Let me ask you something. How much do you think an appraisal for a large, 300 acre tract of land will cost? $500? $1000? Actually, it’s anywhere from $5,000 to $20,000, depending on the type of appraisal you need. When I tell beginning investors this, it often shocks them. Who would think something like an appraisal would be so expensive?

The reality is, lots of things end up costing more than you think they should. It’s common to underestimate:

• Closing costs
• Interest payments
• Repair costs
• Taxes
• Utility costs

Not only do these costs drive down your return on investment, but they can also put you in financial trouble. For example, let’s say you have $10,000 to invest, and you can get approved for a 90% loan to buy a $100,000 house. You’re set, right?

Well, not necessarily. It’s usually safe to budget 2% for closing costs, which includes origination, attorney, and other miscellaneous fees. That’s an additional $2000. Then you might have to pay some of the property taxes in advance, which could add up to several hundred more dollars. Some lenders also require you to make the first interest payment on the closing day. That’s at least $300 more.

Suddenly, you can’t afford the house.

What’s worse is when investors buy a house with the plan of fixing it up but underestimate how much it’s going to cost. I’m sure there are some reputable contractors in the world that can accurately predict how much something is going to cost, but they are exceptionally rare. Expect to pay at least 20% more than you think it’ll cost, and I would recommend having enough funds and profit margin for 100% more.

The same principle goes for interest payments. If you’re on an adjustable rate mortgage, always plan for the interest rates to increase. Calculate how much the payments could reasonably go up by, multiply that by the number of payments you expect to make, and then multiply by two. Hopefully it won’t happen, but it might, and you don’t want it to bankrupt you.

The same principle goes for just about everything. I’ve been in the real estate business since birth, so you could say I have a pretty good handle on costs, but I still add up everything that could cost me extra money and increase it by 20%. For beginners, I would recommend doubling your estimates. If there’s still enough equity to break even, then it’s probably a good deal.

Am I just being conservative? No, I’m actually a rather aggressive investor. It’s just that extra costs do pop up, and if you’re not ready for them, you can land in big financial trouble. You can miss mortgage payments, ruining your credit, or even slip into bankruptcy because you underestimated costs. Take steps to anticipate them now.

Plan for Everything to Take Longer Than It Should

Have you seen the movie, The Money Pit? In it, Tom Hanks and Shelley Long mistakenly buy a dilapidated old mansion, thinking it’s an perfect condition. They end up hiring a crew of contractors to refurbish it, and the repairs seem to go on forever. Every time they ask the General Contractor how long it’s going to be until they finish, he says, “Two weeks!” Then the whole crew starts laughing.

Yes, it’s just a movie, but if you’ve been in the real estate industry for any length of time, then it’s a remarkably accurate example. People give you the shortest time estimate they can reasonably justify, and then they act innocently surprised when it takes two or three times longer. You can expect it in just about every area of the industry.

To some extent, there’s nothing you can do about it. Anybody with talent can make so much money in the real estate industry that they move at a leisurely pace. Just about everything, from repairing a house, to getting a loan, to selling a house takes longer than it should, mainly because you have to depend on these people and you can’t make them go any faster.

But you can plan ahead.

If a buyer puts one of your houses under contract to close in one month, expect it to take two months or longer. Budget enough money for any additional interest payments, repair costs, extension fees, or taxes. Don’t start running up charges either, expecting the property will close on time. Always assume that it’s going to take longer than it should or never happen at all.

The same goes for everything else. If you hire a contractor to do repairs on a house, they can give you a projected timeline with the best of intentions, but they’ll almost always overrun it. So will bankers, appraisers, and realtors.

For example, my family’s real estate company regularly borrows several million dollars at a time for different real estate projects. Each time, we have to go through a long paperwork process, comprising hundreds of pages and several board reviews. But what does the banker say? “Oh, we should have this finished in three weeks.” Three or four months is more likely.

So, what do we do? We apply for a loan four months before we actually need it. Then we find out when the board is scheduled to review the loan paperwork, and we make sure they have everything at least one week in advance. Like clockwork, they always think of another document they need to make a decision, and since we were a week early, we have time to dig it up and send it to them.

You can take the same approach with everything:

• When a contractor gives you an estimate, project it to take twice as long. Then make a habit of stopping by every day or two and inspecting the work. If they don’t know when you’re coming, it keeps them working faster.
• When an appraiser tells you they’ll have a price for you in three days, plan on a week. If you’re buying a property, ask the loan officer to order the appraisal as quickly as possible, so it’s actually completed when the lender needs it.
• When your newspaper says the next big development one street ever will be complete in six months, plan on a year. If you’re planning to make money from the resulting appreciation, try using an option that gives you the right to buy the property a year later. That way, you’re not making interest payments while you wait.

It’s kind of like dealing with someone that’s chronically late. You know the type. If they are supposed to be somewhere at at 10:00 AM, then they’ll show up at 11:00 AM. So, you tell them that the meeting is at 9:00 AM, so when they are an hour late, then they’re actually showing up on time. It works the same way here, just on a larger scale.

Don’t Let Murphy’s Law Strangle You

After reading through this post, you’ve probably recognized a common theme: Planning. Regardless of what you do, people are going to break their word, projects will overrun their budgets, and you’ll go years without saying something happen on time. The only thing you can do is prepare.

If you don’t, Murphy’s Law can bankrupt you. Trust me, I’ve seen it. When you buy $10 million of land, you’re paying $75,000 a month in interest carry, you budget 12 months of interest, and the project takes one month longer than expected, it’s awfully painful, if not devastating, to write a $75,000 check out of your personal savings. It’s happened to our business several times.

The same is true on a smaller scale. When you buy a house for $80,000, budget for $20,000 in repair costs, and it takes $30,000 to complete everything, then you have two choices. Find $10,000 to complete it or leave it unfinished and hope someone else bails you out. The only problem is, unfinished houses don’t sell nearly as fast finished ones, and you might not be able to make the payments every month. Then the house can slip into foreclosure and ruin your credit.

I’ve seen it happen, but it doesn’t have to happen to you. If you understand Murphy’s Law, then you can assume something will go wrong and then get ready for the most dangerous possibilities. As the saying goes, “Hope for the best, but prepare for the worst.” This is the key to survival in real estate.