Looking at my first deal

General Real Estate Investing
1

Howdy all!

I’m an unemployed software developer and have roughly $50,000 in the bank. I’m thinking about buying a rental property, and there is one I found online that caught my attention.

It has three units with a gross rent of $1,660 a month. The asking price is $75,000, but the tax collector appraised it at $117,500

  • $19,920 scheduled rent
  • $4000 for vacancy (20% of scheduled rent)
  • $3900 stashed away for future repairs (assumes I will spend $117,500 on repairs over 30 years)
  • $3800 mortgage (60,000 borrowed @ 6%)
  • $2800 for tax
  • $2000 for water/trash (tenants pay heat, electricity)
  • $1200 for rental company (they charge 6% of gross rent)
  • $500 for insurance

$1720 left over.

$1720 is a return of 11.46% on the $15,000 I put down.

Is there anything I’m forgetting about? Does my thought process seem reasonable? If this looks good, I plan on calling the realtor and asking for

  1. Any leans that are currently on the property or were on the property within the past three years (I’ll probably want to follow up with this city on this as well)
  2. Tax statements for the last three years
  3. Rent records going back three years
  4. Maintenance records going back as far as the seller has them.
  5. Any known code violations (and I’ll also make sure I bring in my own inspector before potentially closing the deal.
2

Use the worksheet below.

This will help organize your analysis and suggest some things you haven’t considered.

The preliminary analysis shortcut I use:

I take half the GSI and call it my NOI.

My NOI is what’s available for debt service. If there’s anything left after that, that’s my cash flow.

Then I use the worksheet with actual numbers to see how far I’ve deviated from my preliminary assumptions.

That is, I confirm how far off from 50% of the GSI, the NOI is, after I’ve filled in the worksheet using the seller’s numbers.

Why would the numbers vary from 50%? If the building is newer, and the tenants are paying for everything, and there’s no common hot water, no common heat, no galvanized plumbing, no flat roofs, etc. Then the 50% rule might not come true.

The usual thing missing from operating numbers is replacement and reserve costs, if not the full management costs, since the owner isn’t actually budgeting for major replacements, and is not hiring professional management.

Some sellers haven’t done a lick of routine maintenance in three years, and so their operating data looks great a first blush. Well, sure it does! When you’re pocketing operating capital…!

In those cases, we we’ve got to plug in the numbers that we know are standard assumptions.

For example, we assume 3% of the GSI for exterior maintenance, and 7% interior maintenance. PLUS 3% for replacement/reserves.

Onsite Management; 7%. Off-site; 3%. That’s 23% right there. Now, we’re on to taxes, insurance, utilities, etc.

BTW, some seller’s numbers are often so sketchy, if not un-categorized, that we can’t really see where a savings can be made, or where too much is being paid, or where costs are being underestimated in a particular category.

You’ll find that most sellers fail to incorporate reserve/replacement funds into their expenses. This would be for 10-year, flat-roof replacements, parking lot resurfacing/striping, pool resurfacing, pump replacements, and other major equipment replacements, etc.

Meantime, I think you would do yourself a big favor by treating this particular deal as an “analysis learning experience,” rather than a deal you want to buy.

Otherwise, you may be getting the cart before the horse. You want to analyze at least 100 operating data sheets from various sellers and projects and learn how to analyze and interpret what you see. Soon, you’ll become an analysis expert and realize there’s a potential deal-of-a-lifetime, every month sitting in front of you.

That just means, there’s more potential deals than you’ll EVER have money to buy.

So, don’t get in a hurry, and nurture some scarcity mentality, where you allow yourself to believe that you ‘have’ to have a deal, because there’s never gonna be another one like this one.

I found that the deals of a lifetime, are the ones I made, not dropped in my lap.

Meantime learn the craft, so you can create your own ‘deal of a lifetime’, every month, until you run out of other people’s money.

You’re off to an excellent start.

That was quite a sermon there…

http://jaypalmquist.com/images/real-estate-analysis-form.png

3

Here are my thoughts on it. Your vacancy rate seems to be about 50% high. Usually vacancy is estimated at 10%. Check with property managers or qualified real estate agents to double check. Also,your estimate for property insurance seems low. Use 10% of gross income or $1,992. Your utilities sound high too - if the tenants pay heat and electric.

Typically investors put 50% of gross income towards expenses. These include vacancy, taxes, insurance, maintenance and capital reserve. The 50% does not include property management or the mortgage. Using your higher rate of property taxes, 6% for a property management company (if unemployed, I would manage it myself and keep the extra $1,200 a year) and $4,317 for mortgage (not sure where you got your number). You are looking at a monthly cash in pocket profit of $303. Right on the investor target of $100 a door.

4

I got a response from the realtor who is trying to sell the property on some questions I asked. I’ve also rethought about the numbers.

I guess the only two things I really know for sure are that the previous landlord said $90-$120 a month for water and sewer (so I’ll use $1400 a year), and that taxes are $2,800. My next most confident figure is vacancy. As I think about it more, I agree with you that 20% was overkill. I think occupation of 12 months followed by 2 months of vacancy is more realistic while still being conservative. So that is $2,800 a year.

That’s $7000. That leaves me $2900 for my repair fund, and insurance.

I don’t know if 6% is the going rate for a non owner occupied rental, but I have an appointment with a loan officer on Wednesday. I’m thinking about pitching $20,000 down and borrowing $55,000 for 15 years. That would be 464 and change a month (call it $5600 a year), leaving me $4,300 in profit (21.5% per year return on my $20,000).

Also, $900 a year in maintenance seems low to me and $2000 in insurance seems high. Regardless, I have $700 a year to spare in cash flow that I can kick in before I fall below the rule of thumb for $100 a door. I’m feeling pretty good with the numbers.

Even though I’m a little nervous about being a landlord, I can see why you are encouraging me to manage the property myself since I’m unemployed. I can always bring in a management company if I feel overwhelmed though. Even without cash flow, I’ve earned 9.7% on my $20,000 if I sell the property 15 years from now for 75,000.

I feel like this post is a little scatter brained, but reading all your (and javipa’s) comments has made me ask myself some questions I wouldn’t have asked otherwise. I thank the two of you for that.

5

Summary of Operating Data

Amount Description
$19,920 GSI (Gross Scheduled Rent)
<$ 996> Less Vacancy/Credit Loss (5%)
$18,924 GOI (Gross Operating Income)
<$ 8,964> Less EXP (Expenses 45%) Inc/ 10% Maint., 10% Mgt.)
$ 9,960 NOI (Net Operating Income)
<$ 3,800> Less Debt Service, $60K @ 6%
$ 6,160 Pre-tax Cash-flow

13.2% CAP Rate
02.1% Rent/Price Ratio
41.0% C.O.C. Return (Cash On Cash) Assuming $15K down.

On a building this size, forget the $100/door rule of thumb. Those kinds of ‘rules’ apply to a critical mass of units (ie: 20+ units, etc), not a triplex. However, each investor has his own minimum limits depending on his market.

In this case, I’m looking for at least these factors, not just one.
a. Appreciation rate potential (which results in higher rents, but doesn’t necessarily include doing much else to the property).
b. Velocity of loan pay-down (which is dependent on what financing amortization schedule the property can support).
c. Potential “forced appreciation” (upgrading the units, and raising the rents).

Bottom line, this is a really good deal, IF the expenses can be brought under control as illustrated above.

Just for giggles, the per door cash flow is $171/mo

P.S. The tax collector’s appraisal means squat. When you come across old properties, the appraisal figure will likely be based on the last date it was sold, plus misc. increments approved by law. These figures have nothing to do with actual value. DO NOT consider them when analyzing a deal. The only thing that makes difference to you regarding value are 90-day old, or less, sales comps.

6

I spoke to the mortgage loan officer this morning at my local credit union I bank with . He complimented me on the research I did prior to our meeting and talked about some rental properties he owns. He also advised me about worst case scenarios - If you decide to go with a property manager and they go belly up, are you prepare to manage? Can you go six months without rental income? Even if you do your due diligence with screening tenants, what are you going to do if he trashes the place? Things like that, etc…

I thought it was a good discussion, but he doesn’t feel like I’ll get approval if he submits a mortgage application to the underwriter. He took issue with three things:

  1. I’m currently inbetween jobs
  2. I have one credit card and car loan, but no other credit history
  3. I have no property management experience.

I found it quite interesting how he talked about the underwriting process and the concept in layers of risk. Shortly before I left, he recommended I read two books, both by Robert Kiyosaki - “Rich Dad, Poor Dad”, and “The Cashflow Quadrant”. He also strongly encouraged me to buy a two unit, live in one of them, and personally manage the other so that I could get a feel if real estate investing was for me.

Javipa mentioned that I would be doing myself a favor if I analyzed 100 properties before making my first purchase, so I’m tempted to pass on this property. I could sort out my job situtation, read the books, and maybe analyze a few other deals to get experience before coming.

One thing that crossed my mind though is the thought about offering the seller $550 a month for 15 years or $375 a month at $25k down. I guess I’m curious how that would impact my tax deductions? With a formal mortgage, the bank would tell me how much of each payment is interest and how much is principal. With a private deal like this, I wouldn’t have that.

7

Anything under five units, and the bank is looking at your financial capacity and history. It’s just reality.

A MUCH better way to go, is to take title sub2 at the get-go, and then after a year, or more, begin looking for a refinancing source.

Your financial capacity is still a factor, BUT you’ve got a history of management and performance to back up your application…! Those are major bonus points.

After two years …with a successful operating history, you will find the financing you need.

Seller financing is VERY powerful both when buying and when selling.

In fact, the worse the property is (to a point), the more likely the seller will consider financing you 100%, regardless of size… If things are too far gone, it’s more likely to become a cash-only transaction.

Do your homework on the 100+ operating data statements, and then sift for seller financing ONLY, as your first step into buying investment property, and you’ll just knock your investing goals out of the park.

EXTRA CREDIT READING:

Introducing the idea of financing the entire purchase price:

I might pitch it this way:

"Mr. Seller, if your property were performing better, I would just put 20% (or whatever) down, and try to get a new loan for the balance.

But in your case, your property isn’t performing as it could, and I would need to put two down payments down; one to buy the property, and another to turn it around. Not to mention, the reserves I’m required to have, on top of the down payment, and the turn-around funds.

At this price, and financing requirements, the property just doesn’t make enough financial sense.

However, if you’re willing to finance the price on this property, for a short period of time, while I invest my time and money into the turn-around, all of the sudden the deal makes better financial sense, and I may be able to buy it."

This dialogue fits so many under performing projects it’s probably ridiculous.

However, it’s primarily a matter of being the first investor to suggest this to a motivated seller, and taking action.

Meantime in my experience, single families/duplexes/triplexes are probably the most dangerous investments possible. The potential financial loss is greatest at this level.

One a/c compressor melt-down and a 30-day skip, can disrupt your COC return for a couple of years on a house. Add two 30-day skips, and a broken a/c, and you’re likely not to see an actual return for the foreseeable future.

That’s why banks want to see reserves, and some management experience on these small properties, because …crap happens.

As an aside, the more units you own together, the more you can amortize the cost of both management and maintenance.

I like 30-units and bigger for this reason.

And it’s just WAY easier to get refinancing on about any project, if you have positive, two-year performance history, you can show the lender.

And the dirty little secret I alluded to earlier is that …it’s really tough to find strong enough buyers to buy under-performing units without significant seller participation in the financing.

The sellers OFTEN have to offer, at least temporarily financing, to get their properties sold …even on performing properties.

Even so, there’s a sweet spot between foreclosure candidates, and just sucky numbers. You want sucky numbers that can be fixed with professional management applications. Not sucky numbers, because the plumbing system and roof are both missing… Just saying. However, there’s lots of money to be made on mechanically and structurally dysfunctional properties, too.

Man, I want to unload here, but nope. Not gonna do it.

Do your homework first. :beer

8

Okay - back to reality. Investing in a 300 unit as a first property is going to freak out a loan officer as a first time investment than a tri-plex.

First, never by property for the tax right off. Do not even think about tax benefits because the reality is that there are not any. Really. Say you are in a 30% tax bracket. For every $100 you spend in interest, taxes etc, you get to write off $30. But, you had to spend $70 to write off the $30. See what I mean?

Second, the lack of income is what will hold back your loan. Lenders do not want you to solely rely on rental income to pay the mortgage. That is your hang-up. Everything else the lender was saying was to soften the blow.

Third, if the seller will owner finance. That is by far the best way to go! Give him as little of a down payment as possible and make the payments to him. He is going to charge you interest (which you can write off but remember we are not thinking about the tax benefits right?). It is easy to amortize. There are lots of free websites and Excel spreadsheets that will do that for you.