How I'm falling into real estate...

General Real Estate Investing
1

Okay, so I finally did it. It took me 13 months longer than I thought, but I’m going about this in a little different way.

After searching and searching for rentals, or maybe a good SFH that could cashflow, I happened to come across a very nice foreclosed house that needed rehab. People who left the house took the doors, light fixtures, knobs, pulls, etc all out of the house. The house used to be a model home so the other details of the house are all there all the way up to the $2000 water fixtures. So what we did is we bought the house st 65% of the previous tax assesed values. After all repairs are taken into consideration, we should have about 30% equity in the house. Even better, we moved into it.

Instead of selling our current house, we are turning that into a rental since we’re in a down market. I’m hoping to rent that at $500 per month over my current financing on it. After tax and insurance we’ll still clear a few hundred a month. Now I know under the slumlord formulas for repairs, I should be leaving half a months rent for expenses, which I’m not doing. It’s more like 35%. But considering $1500 - $2000 rental values, I can’t see monthly repairs and expenses at 50%.

So depending on whether this works or not, I either created a nice rental with some right offs, or else I lose money with headaches for a couple years and then sell that house at current market value whatever that is. (Currently holding about $80,000 in equity as the market sits right now, hoping if market comes back a bit in a few years I maybe get $100 - 120k in equity).

Thoughts, concerns, comments?

(By the way, this is way more fun and educational than me continually going to expert seminars that cost thousands of dollars).

2
I should be leaving half a months rent for expenses, which I'm not doing.

Yep, that’s right.

It's more like 35%. But considering $1500 - $2000 rental values, I can't see monthly repairs and expenses at 50%.

That’s what all the failed landlords say!

Good Luck,

Mike

3

Hopefully 35% repairs and expenses is excluding things like taxes and insurance and you were including those in your mortgage payment numbers. If that is the case, then you might be accurate; if not, get ready for some headaches.

4

Okay, so far from the comments I’m on my way to failure. (No wonder people do not get into real estate… it’s also the reason I didn’t ask people here if I should do the deal before I did the deal… too many naysayers).

So if you were me at this point, would you sell the house that I’m planning on renting, and run with the $80k in equity, or do you rent and have someone else pay off your mortgage for a couple years and then sell in a hotter market which would realize and additional $40 to $60k?.

Part of the reason for the deal is that I can use the tax deductions at 28% so from the calculators I’ve used, at worst I come out even on cash flow after expenses, assuming no appreciation (in the fastest growing county in the state) and I’ll come out ahead in after taxes cash flow. (Not to mention networth).

Also, would I have been better off not buying the house that we moved into which after repair will yield us 20 - 30% equity in the current market?

5

It’s not just a formula for slumlords. It is the average expenses on a rental property across the US. Not just a formula to make sure you can cash flow on some house in the ghetto. Also, if simple “naysayer” (as you put it) keeps someone from getting into real estate, it’s probably for the better. That way they don’t ruin their credit, cause the bank to lose money on foreclosures and cause property values to go down when someone else purchases that vacant house way below value.

Besides that, it’s your money on the line so do what you think is best. I can’t say that you’ll fail.

Why don’t you find a lease option client that you can put in on a rent to own. Get a sizeable down payment up front and charge a little higher than market rents - then if they screw up, you have their up front fee to pay for it. Better yet, if they end up buying, you sold at retail value because they needed a lease/option and you worked with their bad credit.

6

I understand that 50% expenses is the “Average” across the US. If that’s the average, are there not areas above and below 50% as the average?

So can someone explain to me how a single family house in a top 100 fastest growing county gathering $2500 in rent a month incurs $1250 in expenses vs a slumlord special rental in the bad part of town which gets rent of $250 per unit only has $125 in expenses per month?

My assumption is that the tendency would be for the tougher areas to be a little more abusive on the property, but the 50% formula proves me wrong. In fact, my expense of owning a unit in one of the least desirable (slowest growing, poor economy) areas (according to the formula) are over $1125 CHEAPER PER MONTH than a desirable area in a fast growing area.

That’s remarkable.

What social behaviors take place that make the less desirable areas less expensive?

7

dd564,

If you didn’t post the question on this board BEFORE you bought the property due to the “naysayers”, why ask their advice now? There are a lot of knowledgable people on here that share their expertise for free. You should’ve had a plan for the properties before you bought them. Part of formulating that plan is to ask experienced successful investors their thoughts before doing the deal. Which you would’ve gotten if you posted the deal for them to see here.

8

You assume that a nice neighborhood makes for better tenants. Just because someone lives in a tough area, doesn’t mean they don’t, or can’t, take care of a property. The same holds true for wealthier neighborhoods. Those reality shows on TV for “clean house” and “clean sweep:” "Organize me " or what ever their title… dey ain goin to the ghetto to film those shows.

May also want to check that you can legally turn your property into a rental.

9

The reason I’m posting now is because I’ve been on this board for a while a read a ton of the advice. In this case, after running the figures on my side, gaining 30% equity on a new house while going break even or for a couple years on a rental, (and likely after tax positive cashflow) it seemed to make sense.

So the reason I’m asking peole’s advice is because it’s a real world scenario. So far people have said it’s not a deal, but no one has stated their opinion on the right thing to do now.

As I mentioned, so far the feed back is that it’s generally a bad deal, where in the worst case scenario I either sell the older property and pocket the equity, or I sell the new place, move back to the old and make 25% equity in that house.

Depending on expenses, (and I still don’t understand why mine should be $1000 MORE A MONTH for expenses than the $250 rental in the slums. My tenants would have to be 5 times worse. ($250 per month expenses vs $1250).

I’m the rookie afterall so the only way I’ll find my real numbers is by trying this.

10

By using 50% of rental, I am NOT assuming a nice neighborhood makes for better tenants. By using that formula I’m assuming my tenants are 5 times worse. ($250 in expenses on a $500 rental vs $1250 on a $2500 rental).

By using that formula, the AVERAGE $2500 per month rental will yield $1250 per month in expenses. That’s amazing. That’s and extra washer and dryer every month they are stealing each month while I keep them as tenants.

11

ok, let me try a different approach for you…

Let’s say I’m a tenant. I find a $600/mo rental in a tough neighborhood. I live there for one year. I don’t trash the place, but when all is said and done, I’ve ruined a couple doors, put a couple holes in the wall, dented the floor trim and ruined a couple vinyl tiles. The landlord fixes everything and I skip town. Doors: $10 each. Floor trim: $0.50 per linear foot, vinyl tile replacement: $2.50 total. Patch drywall: $5.00.

Now let’s say I’m a tenant for a $2500/mo rental. I ruin a couple doors, holes in the wall, ruin floor trim, crack some ceramic tile. The expenses are going to be MUCH higher than the other rental, for the simple fact that everything in the house costs so much more and is higher end. Not to mention taxes, insurance, and all the other things that cost more.

Do you think the insurance and taxes are the same for a $20k house as it is for a $400k house?

That’s just a couple examples. Hope this helps.

12

dd564,

From a fellow newbie, good luck. This deal wouldn’t work for a full-time RE investor but may work for you. It’s better than sitting on the sidelines going to seminars. I lost about the cost of a seminar on my first deal but learned more than 10 guru seminars could teach.

My first concern would be cash reserves. You don’t say where you’re located but in my area anything over $2,000/month takes awhile to rent. Also, do not assume that because you have a high-end renter you don’t have to worry about evictions which could also be expensive with you carrying $2,000/month in financing. What happens if you can’t get your estimated rent and have to lower the rent? You should have about 6 months cash reserves.

Next would be to screen prospective tenants, have proper lease paperwork, don’t turn over keys until all paperwork is signed and rent and security deposit paid with secured funds.

I like the lease/option suggestion because at best there’s about a 40% chance that your tenant will close. The option consideration can offset your potential negative cash flow.

Good luck with your REI.

13

dd,
You probably are partially right, but only time and volume of similar deals will tell.

Some things to think about.

expenses don’t just account for things that happen every month. They also account for the once every 20 years type of expenses. (replace the roof). On your nice house, maintenance, as has already been pointed out, is much higher than a cheaper house.

be careful that if everything goes well ( good tenant, no problems, no evictions, always pay on time, etc. ) that you don’t start to think that this is what you can expect all the time and start to figure your expenses lower and lower. Its a game of averages and if your first house happens to be the one that works great and only takes 30% expenses, don’t let that sucker you into the deal that will eat your lunch.

You are correct to say that the 50% rule is an average, hence some people do better and some worse. On which side of the average do you think most new landlords fall? Is it the experienced or inexperienced landlords that are able to keep costs down?

This deal probably won’t do you a lot of harm as you pointed out the worst case was something you could handle, but if you do a lot of these, and the big nasty one comes along, it could ruin you.

Just some thoughts,

DB

14

dd564,

Let me offer you a different angle on your deal. I’ll skip discussion about your rental income and expenses as that has been pretty well analyzed by your fellow forum members.

If you owned the old house and used it as your primary residence for at least two of the last five years then you can sell the home and take any gain tax free up to $250,000 for a single tax payer. See IRS Publication 523 for details. The beauty of your situation is that if you keep the new house as your primary residence for at least two years you can then sell it and take any gain tax free yet again. So while you may or may not cash flow on the rental aspect if you meet the IRS requirements and sell the properties your gain(s) will be tax free. That is like getting a 25%-43% bonus on your money.

15

Another thing to consider is that tenants are VERY hard on rentals. Rent out your expensive home for a year or two and it could easily need to be rehabbed before it can be sold.

Mike

16

Well first thing is you went from initially saying 1500-2000 in rents, to now saying it’s a 2500 dollar rental price. Which is it? That’s a $1000 spread.

Also the reason that your expenses may be greater is because a higher end home will require more maintenance. Let’s say your tenant moves out and trashes the place. Now you have more expensive carpet, nicer cabinets and everything else all the way around to replace, and it will get expensive. A little different than coming in and painting the cabinets and floors and patching a little drywall and then spraying all the walls white.

And the 50% rule always covers vacancy, taxes, insurance as well. Those 3 things will cost you more with a higher end rental.

Have you lived in your current home for 2 years? If so, why not sell and pocket the entire profit tax free? Then take that and invest in something more profitable…

17

Bingo. See, you’re thinking the same way I am. We lived in the house the last 7 years, so I need to sell in three years to still keep the tax deduction. In the mean time, I can definitely use the depreciation and rental expenses, interest expense, etc for write-offs on taxes. (I know write-offs aren’t the goal of a rental business, but it sure doesn’t hurt when you have a full time job on the side). So basically, the write-offs will offset my high rate of income taxes (I live in MN where state and federal income taxes both bite ya) while my tenant pays more mortgage for two years.

The county I’m in is the fastest growing county in MN over the last few years and since my family was ready for the move to a larger space, this was a good market to buy it. Why not sell now? Basically I’m betting the market will be better in 2 - 2 1/2 years than it is now for selling. If the market doesn’t improve and things get tough, we move back to that house and sell the larger newer house which already has banked equity of 25%. If the market drops to a point I fall negative on that house, 75% of Minnesotans will be getting foreclosed on.

I guess part of my point is I think by handling repairs by myself in spare time, I’ll be able to keep expenses lower. I do understand the higher costs for the higher rentals which is a concern of mine. (Repairing nice floors rather than cheap carpet).

Part of my current strategy is to by nice homes that are beaten up, live in them for a couple years, then sell them. If I can sell a couple homes tax free, that’s a good supplemental income, plus my family lives in a nicer house for a few years as a side benefit.

18

dd564,

Will you be able to get rents at $2000 - $2500/mo.?
Are you saying those rents are cheaper than a $250K mortgage?
Are there any homes that are selling for $250 - $300K?
If so, Why would someone rent when they could own?
How does your property compare to the competion in your area?
What are the drivers behind your market rent rates?

You never gave actual numbers in your deal for anyone to look at.
How much did you pay for purchase,rehab, holding costs?
What is your mortgae payment?
Instead of renting your house for $500 more than your mortgage, why wouldn’t someone just buy a house instead of renting?
These are all important questions that need to be answered before the purchase. Lay out all the actual figures and perhaps you’ll get some direction on what to do next.

19

Hi,

Purchase price on the new house is $425,000. Put 20% down. Prior to that the down payment was gathering 4.5% interest on straight savings. Cost to rehab is $35,000. Last purchase price was $670,000. (2004). Previous tax assessed value is $620,000. Lot value without the house is $220,000.

Last house has mortgage of $1100 with 24 years remaining. Rent will be at $1650. My costs after taxes, insurance, is $1450 per month. Figure expenses are 50% of rent, that would be $875 per month. (I feel that’s high).

At the end of one year, my expenses will be $10,500. My rental income will be $19,800. My mortgage payments will be $14,100 for the year. If expense are 50% I lose (24,600 expenses - $19800 income = $4,800.)

I write off the $4800 in expenses of income tax. National income tax rate that I’m hitting is 28% after my other deductions. State rate is at 7.05%. Combined that’s 35.05%. (This doesn’t include mortgage interest as a deduction). At 35%, that’s $1682 of income tax savings.

So now instead of being down $4800, I’m now down $3117.60. But let’s not forget, I’m gaining (non-appreciation) equity in the house from my mortgage being paid down on the rental at an average rate of $302 per month. That’s an additional $3624 I gain in net worth. So subtract that off the $3117, I’m plus $500 bucks my first year before any appreciation. This is still using the 50% expenses rate which I think is high for our area. I just put a new roof on that house last fall, I’m hoping I’m not buying one every year.

Also, what I haven’t written off yet is any depreciation on the rental itself. At a collective rate of 35% income tax, depreciation should be a nice little bonus. So an additional $5000 to $7500 in depreciation should yield me an additional $1700 to $2500 in tax savings (not we’re getting out of that high bracket though soon).

Now MY GOAL is instead of paying $875 in expenses per month… I hope to ONLY pay $500 per month in expenses. (About $200 - $250 after taxes and insurance per month). If I can do that, I pocket an extra $4500 a year.

So if I sell the house, pay the realtor his share, and then IF I can collect 7% in the stock market, I’m in the same spot, but I’m not in a position where I want to throw more money into the market the way that’s going.

With all of that said, with a buyers market in housing, a little luck, the market is better in two years and in the area I’m in where appreciate is likely to happen, I can maybe add $50,000 of tax free equity if the market should happen to heat up before then. So really, I’m trying to buy some time. At worst, I keep renting.

20

“Also, what I haven’t written off yet is any depreciation on the rental itself. At a collective rate of 35% income tax, depreciation should be a nice little bonus. So an additional $5000 to $7500 in depreciation should yield me an additional $1700 to $2500 in tax savings (not we’re getting out of that high bracket though soon).”

If you sell and not do a 1031 you have to recapture the depreciation. Your short term gain could turn into a tax hit even though it was a primary at one time.