A reader of my blog, Jim*, reached out to me for advice. Several years ago, he got a good deal on a house that needed significant repairs, both inside and out. Off to work he went, demolishing the inside as part of a massive renovation project. Unfortunately, in the interim, his source of income dried up and he also developed a problem with his back. The renovation project was put on hold while he scrambled to earn a living and pay the carrying costs for the property (i.e. mortgage payments, utilities, property taxes, etc), all of which strained his already-pinched cash flow situation. Today, the city is on the verge of taking him to court and he still doesn’t have the cash to complete the project. He insists that he should be able to finish the renovations with a lot of help from friends, but the help has not yet been secured.
He wants to hold on to the property because it has a great deal of potential and besides, he has already spent a lot cash on it. If he sold it now, he would lose money. He feels that he needs to hold on to be able to recoup his investment. He was hoping that I could offer a creative solution.
The real question here is this: should Jim hold on to his investment or sell it?
Let’s break down his situation.
Before you spend money on an investment, you need to know why you’re doing it. Is it for cash flow? For growth? For re-balancing assets? In this case, Jim saw an opportunity to buy a run-down property at a good price where he could benefit from forced appreciation through renovations. He could then live in the property (i.e. an inexpensive primary residence with built-in equity) or rent it out for cash flow. Since he was not a home-owner at the time of the purchase and he had a good, steady income, this wasn’t a bad plan. So far so good.
If your goal is to renovate a property, then you need to create a realistic plan about a) how much time it will take, factoring in plenty of Murphy’s-Law buffer; and b) the cash requirements for the project. How much money will it take to get the property rent-ready? How much will it cost to carry the property until you can start producing an income or until you can live in the place?
In learning about Jim’s situation, two things became clear: First, Jim had been wildly optimistic about the time required to complete his renovation, and second, he had not done a careful cash flow analysis.
How will you finance your investment? Do you have sufficient cash reserves to withstand problems, cost-overages or losses? In this case, Jim was relying on the income from his job to finance the project. He had no savings or financial backing of any kind. When his income dried up, he was in big trouble.
This is where you want to spend a lot of time evaluating a potential investment and take off the rose-coloured glasses. In Jim’s case, it was too late; he had already bought the property and sunk significant resources into it.
We have a tendency to get excited about the up-side to an investment while minimizing the potential downsides. That’s human nature and we all suffer from this bias. But what if something doesn’t go according to plan, what would you do then?
If you’re undertaking a significant renovation for an investment property, you should assume that the minute you open up the walls, you will discover a nasty surprise. Count on it and factor it into your cash and time projections. If no major issues present themselves, you’re ahead of the game. If they do, you’re prepared.
If you’re planning to do the work yourself, what happens if you are unable to complete the tasks for any reason? Who will replace you and how much would that cost?
If Jim had asked a few “what if”-type questions, he would quickly have recognized his vulnerability if something happened to his income or his health. In his industry, it’s often feast or famine. I personally wouldn’t count on feasts. I would plan for them, but I wouldn’t count on them.
Jim has two fundamental choices with respect to the property: sell it now, at a loss, before being dragged into court with all of the attendant consequences, or hold on to the property and face an uncertain future. In order to argue in favour of holding on to this particular investment, I would want some or all of the following to be true:
BOTTOM LINE: The limited possible gain is not worth further risks and costs, nor is the gain likely to materialize at this point. I would sell if I were in Jim’s shoes.
Despite all of this, I suspect Jim is determined to persist with his investment. He is stuck in a well-known trap: the Sunk Cost Fallacy and Loss Aversion. In a terrific blog post about the sunk cost fallacy, author David McRaney says the following: “As an emotional human, your aversion to loss often leads you right into the sunk cost fallacy.” Jim spent a bunch of money on the property and renovation materials. He is holding on for dear life because he doesn’t want to lose his investment. What he doesn’t realize is that by doing so, he is putting himself at much greater risk of loss. The money he spent is gone – sunk cost. It’s time to stop the financial bleeding, sell as quickly as possible and walk away with something in hand before things get worse.
At her recent event, Money, Mindset & Marketing, Lisa Larter shared the story of an entrepreneur who used a business sign with an error on it because he had already paid for it and didn’t want to spend more money to have it fixed. Lisa’s reaction was bang-on: “Just because you invested in something doesn’t mean you’re invested for the rest of your friggin’ life! Let go of sunk costs.”
I get it. It’s never fun to lose money, but it’s even worse to ride the loss into an even bigger hole. Nortel stocks anyone? The trick is to accept sunk costs and to make the wisest decision moving forward. For Jim, that means selling the money pit and getting his life back on track. For Lisa’s entrepreneur, that means accepting the mistake and spending the money to retain a professional image.
If Jim does continue to hold on to the investment, he will spend not only more money on it, but also more time in trying to deal with the mess. I’m a big fan of considering the ROE for a project – the Return On my Effort. You can always make more money, but you can never make more time. Wealthy people protect both. They work hard to protect their money and they allocate their time carefully. If an investment is losing money, they consider potential future losses and act decisively to curtail the damage. Their efforts are then turned to more productive pursuits.
I get how hard it is to accept, learn and move on. I have fallen for the sunk cost fallacy countless times. But after years of experience, I have learned to view sunk costs either as options (e.g. I buy tickets to a concert and treat them as an option for that evening; if I’m sick and can’t go, so be it, I give them to a friend) or as lessons.
Failure is informative. It can help you grow if you learn from it, but first you have to recognize the situation for what it is. Knowing when to walk away from an investment is a powerful skill.
*Not his real name