Whenever you are doing financial transactions it is imperative that you work out the math ahead of time to make sure you are getting a fair deal. If you do not work out the math ahead of time you could very easily accept a bad financial deal.
The larger the financial transaction the more imperative it is that you work out the actual math involved in the transaction to make sure you are getting a fair deal. Just because a number sounds like it is fair or someone says it is fair does not mean it is and accepting a number in a financial transaction without doing the necessary math ahead of time can cost you a lot of money.
So always do the math for a financial transaction ahead of time. Even if you just do the math in your head at least you will have some idea if the transaction you are doing is a fair one. People who do not do the actual math behind financial transactions are often taken advantage of.
The author will illustrate here using a real world example he is familiar with why you should always work out the math for financial transactions. While it may seem like an obvious point that everyone should work out the math before doing a financial transaction the reality is many people skip the math and end up with bad deals.
Why You Must Do Calculations Before Making Financial Transactions
Three people, call them Owner 1, Owner 2 and Owner 3, bought a rental property together as 1/3 owners each. They rented the property out for 24 years and then sold it.
Shortly after they purchased the property, Owner 3 got a job offer in another state over 1,000 miles away and he moved there. So over the 24 years of ownership, Owner 3 did zero work regarding the rental property. Despite that, he did receive 1/3 of the free excess cash flow that the three owners paid out equally over the years.
Owner 1 was a business graduate from college and he assumed the bulk of the work with the rental property. He recruited all the tenants, then dealt with all the tenants, handled all the finances and did the vast majority of work over the 24 years the three owners owned the rental property. He also handled all the work involved with selling the rental property.
Owner 2 did do some of the maintenance work on the rental property (1 - see below). He painted the interior a few times over the years as well as replacing a few appliances and other needed work but over the 24 years, including his driving time, he devoted only about 100 total hours to the rental property. A number he had calculated out and was very well aware of.
Owner 1 never calculated this out but he had devoted roughly ten times the amount of time, 1,000 total hours, to the rental property that Owner 2 did over the 24 years of ownership. That included Owner 1 writing some one-thousand checks, handling well over one-thousand phone calls, emails and texts regarding the rental property and having to drive to the rental property over 100 times over the 24 years to get new tenants and deal with the tenants and to handle things like building a new deck, adding a screen door, replacing broken handle cranks for the windows, doing touch-up painting and other maintenance work even including replacing burned out light bulbs in the refrigerator plus selling the property.
Owner 1 was also on-call 24 hours a day, 7 days a week, 52 weeks a year for 24 years regarding the rental property. He handled all the calls at all times of the day and night when the furnace stopped working, when one of the skylights started leaking, when one of the faucets or toilets was leaking, when one of the appliances stopped working, etc. ..., and then he called the repairmen in to fix the problems. Over 24 years, Owner 1 was on-call for over 210,000 total hours. That alone is worth something and for our purposes we will credit Owner 1 with another 1,000 hours for being on-call all the time for 24 years (slightly under 1/2 of one percent of his total time over the 24 years).
So, in total, Owner 1 devoted at least the equivalent of 2,000 hours to the rental property over the 24 years. (While that may sound like a lot of time in reality it is under one percent of his total time over the 24 years.) Unlike Owner 2, though, Owner 1 did not calculate out exactly how many actual hours of time he had devoted to the rental property over the 24 years of ownership.
However, after the owners agreed to sell, Owner 1 did demand 40% of the sale price and told Owner 2 and Owner 3 that they should each take 30% (2). Owner 2 immediately objected and pointed out that he had done some of the work over the 24 years. He readily admitted that Owner 1 had done the bulk of the work but Owner 2 adamantly refused to take the same percentage as Owner 3 who had done zero work over the 24 years of ownership.
Owner 3 then voluntarily said he would take only 29% of the sale price which he said was a fair amount to give up. Owner 2 had calculated out the minimum amount that Owner 3 should have given up and knew it was a lot more than Owner 3's offered fair amount but did not say so (3).
Instead, Owner 2 suggested a split of 37-34-29 with his amount in the middle. Owner 2 also said that 34% of the sale price was the least amount he would take and if Owner 1 wanted a bigger cut he could haggle it out with Owner 3. Owner 3 responded by saying there would be no haggling he was giving up a fair amount at 29%. Owner 2 debated pointing out how much Owner 3 should have given up but again said nothing (4).
Owner 1 then said the 37-34-29 split was acceptable to him. He did not do any calculations, he just assumed that getting 3 points more than Owner 2 and 8 points more than Owner 3 was fair to him. In reality, Owner 1 sold his labor over the 24 years for a very meager price.
Based upon the sale price of the rental property, Owner 3 gave up about $11,000 by taking 29% instead of 1/3 of the sale price. Based upon his cut of 34% of the sale price, Owner 2 got a little under $2,000 more than he would have gotten if the sale price had been split equally among the three owners. Owner 2 knew from his calculations that since he had devoted about 100 total hours to the rental property over the 24 years he had been compensated a little under $20 an hour for his time. He felt that was a fair and acceptable price for his time.
With his 37% cut of the sale price, Owner 1 received a little over $9,000 more than he would have had the money from the sale been split equally among the three owners. A lot more money than Owner 2 got but Owner 1 had devoted at least 1,000 actual hours to the rental property meaning he only got about $9 per hour for his time. When we add in the additional 1,000 hours we credited Owner 1 with for being available 24 hours a day, 7 days a week, 365 days a year for 24 years his actual compensation rate is just $4.50 an hour ($9,000 divided by 2,000 hours).
Because he did not do any calculations regarding the amount of time he actually put into the rental property, Owner 1 accepted a very low compensation rate for his time. A rate that was well below the rate Owner 2 got for the time he put into the rental property and a rate that is well below any minimum wage in the country. Had Owner 1 done the calculations he would have known how much time he actually put into the rental property and he could have negotiated out a fair rate of compensation. Instead he just assumed he was getting a fair rate of pay.
Owner 2 did do the calculations and knew exactly what a fair rate of pay for his time would be and that is what he got. Whenever you are doing a financial transaction, in order to make sure you are getting a fair deal you must do the necessary mathematical calculations out ahead of time. Just because a number might sound fair or someone else says a number is fair do not assume it is or you could end up with a very bad deal like Owner 1 did in the example above. The larger the financial transaction the more imperative it is you do the calculations.
In the case above, since both Owner 1 and Owner 2 did work on the rental property and Owner 3 did not, both Owner 1 and Owner 2 were really negotiating with Owner 3 to get a fair rate of pay for their time. Owner 2 calculated out how much time he had put into the rental property and what a fair rate of compensation would be and he got that from Owner 3. Owner 1 did not do any calculations regarding the amount of time he had devoted to the rental property and he ended up getting a very meager pay rate for his time from Owner 3.
In reality, Owner 3 got Owner 1 to manage his share of the rental property for 24 years for a very meager price while Owner 2 forced Owner 3 to pay him a fair rate for the work he had done. Owner 3 could not have taken advantage of Owner 1 in the way he did had Owner 1 done the calculations out like Owner 2 did.
Being in business with Owner 1 was a dream for Owner 3 who got someone to manage his business for 24 years for the equivalent of $4.50 an hour (5). Another way to look at it is if Owner 3 asked Owner 1 to look after his 1/3 interest in a rental property for 24 years and offered to pay him $4.50 an hour for his work would Owner 1 have taken the deal? The answer is no but because Owner 1 did not calculate out the finances before making the final transaction that is all he got.
Always do the calculations out ahead of time whenever you are doing financial transactions. If you do not you risk being taking advantage of in the way Owner 1 was in the example above.
Notes:
1. Over the 24 years of ownership of the rental property Owner 2 always made it clear he would take over doing the finances and dealing with the tenants at any time should Owner 1 not want to do the work anymore
2. Right from the start Owner 1 committed a dumb negotiating blunder here. By completely ignoring all the work Owner 2 did on the rental property and lumping him in with Owner 3, Owner 1 threw out the window all the considerable help Owner 2 could have provided him with in negotiating with Owner 3.
3. Owner 2 knew that the cheapest a rental agent would manage a property in his area was 7% of the yearly rent and the agent would also charge a minimum of 1/2 of one month's rent for each new tenant (most rental agents charge 10% of the yearly rent and want one month's rent for each new tenant). The average rent of the property for the 24 years was about $22,000 a year. So 7% of that would be roughly $1,500 a year x 24 years = $36,000.
There had been 9 total tenants over the 24 years. So a rental agent would have charged another $9,900 for 1/2 of one month's rent for each new tenant for total compensation of $45,900. So Owner 3's fair share would be 1/3 of that or over $15,000.
Added to that was another $9,000 to account for the work that Owner 1 and Owner 2 actually did, like painting, replacing the deck, adding a screen door and more. Owner 3 is responsible for 1/3 of that for another $3,000 bringing the total number to $18,000 that is the bare minimum Owner 3 should have been responsible for regarding the work on his rental property for 24 years. Remember, Owner 3 did absolutely no work on the rental property for 24 years.
4. From day one, since Owner 3 was unable to do any of the work and the three owners could not split the work evenly, Owner 2 believed that any work he or Owner 1 did regarding the rental property should be immediately compensated for from the rental property bank account. That included paying Owner 1 a stipend of $50 a month or $600 a year for doing the finances and always being available to deal with the tenants.
Owner 1 did not agree and despite continual protests from Owner 2 he refused to pay out any compensation for any work done beyond expenses for materials. Had Owner 1 been paid $50 a month he would have received $14,400 ($600 a year x 24 years) for doing the finances and dealing with the tenants. Add in more compensation for the other work he did on the property and Owner 1 would have gotten a fair amount of money for the time he spent on the rental property.
This is another reason why Owner 2 remained silent and did not point out how much money Owner 3 should have contributed. Had Owner 1 followed Owner 2's advice about paying out compensation as the work was done both owners would have already been fairly compensated before the rental property was sold.
5. Even worse, after accounting for federal and state taxes Owner 1 ended up with about $3.00 per hour
© Joe Dorish
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