How do you "appreciate" your rental property?

Question

Hello.

In short notes, I wish to buy rental property consisting of a minimum of a 4plex. I plan to live in the property.

How do I make the property appreciate in value, so that in the event I need money or I wish to sell it someday to upgrade, I dont lose money? I know the basics.. IMPROVEMENTS. But how much will improvements really boost a rental properties value?

Al Williamson · Answer

Good conversation! @Matt, sounds like you're set.

Before you start molding the apartment into what you envision, I offer you this tip from my BP blog: http://www.biggerpockets.com/blogs/2997/blog_posts/24033-a-long-term-landlords-guide-to-rehab-a-rental

This guideline has prevented me from going off the deep end. Hope it helps.

David Beard · Answer

Matt M - as a benchmark, rehabbers are usually looking to make 20% profit on the resale price.  Those are typical numbers when selling to owner-occupants.  For a 4-plex, you can potentially sell to an owner-occupant as well (as you are doing), but chances are good that a pure investor will purchase your property when you go to sell.  But the 20% is  a good target for you to shoot for in regards to equity capture, and is very doable if you buy right.

You are going to have the greatest potential for equity capture by buying right on the front end:  (1) dealing with a distressed/motivated seller, and/or by (2) dealing with a distressed property, preferably both.   And the property needs to be in a “decent” area in order to feel pretty good about it’s market value being protected.  Since you’re going to live there, I’m sure you’re looking at nice areas, so that won’t be an issue.  It may well make it more difficult to find the distressed situations, however.

*Motivated sellers* typically need to sell more quickly than a typical seller, or there is a stigma attached to the seller.  Motivated sellers can be estates/probates, out-of-area owners, vacant property and code violation owners, pre-foreclosure/NOD’s, those carrying large mortgages on rentals with negative cash flow, retiring/burned out landlord, bankrupt owners, etc.  “Stigma” is attached to REOs and short sales, and causes them to typically sell at a 10-20% discount to MV.  (Yes, stigma is recognized by appraisers.)  So you want to deal with a motivated seller if possible.  MV/ARV assumes that the property can be exposed to the market for an adequate period of time.  With motivated and stigma sellers, there is always more time urgency.

Most MLS systems identify REOs, short sales, and estates as “seller types”, so they can be easily identified by an agent.  Some of the best deals will be off-market deals, however, and they will require marketing research to dig  them up, and it’s a ton more work.  And of course, check out Craigs List.  Look for both sellers of property, as well as rental ads.  The rental ads indicate there is a vacancy at that property, and that might be an indication of a tired landlord, so call and ask them if they’re interested in selling.   Once you’ve identified the owner, look them up in the on-line property records for your county, see what they own and what they owe, and try to determine if they might be motivated.  Same thing with looking at properties with “For Rent” signs posted in the area of your interest, particularly if the property appears to need some work.  Call and see if they want to sell.  Your pitch is that you're pre-qualified, quick close, no sales commissions, and they don't have to do a thing to the property, you'll  take it as is.

*Distressed property* obviously needs work.  The more work, the more the potential equity capture, normally.  This is because the buyers for beat-up property are fewer, and the financing options are fewer (though if you’re going to occupy the property, such as in your case, there are several ways to finance most of the rehab, then roll  into a permanent loan).  Fewer buyers translates into an imperfect market.  Remember that true MV/ARV assumes that you have a sizable pool of willable and able buyers.  This is not the case with distressed properties.   Bear in mind also that even  a very unappealing out-dated look to the house can be enough to turn off a lot of buyers and create an opportunity for you to buy at a good price.

In a nutshell, you want to find a distressed seller/property, then make the improvements in order to command retail pricing when you go to sell.  This means that your future buyer will need to do virtually nothing to move in or rent out your property, that it is visually appealing to the masses with good curb appeal, that it does not have deferred maintenance, and that it would be eligible for the maximum array of financing options for your buyer.  You also want to make sure that you don’t yourself become a “motivated seller”.  This means that you keep adequate cash reserves on hand so that you can keep the property in top-notch condition.  You need to run it professionally, and use appropriate standards to select your tenants.  You need to make sure that you’re establishing a good baseline of profits for the property on your tax filings, so that your future buyer will pay top dollar.  All of these things will help the bank appraisal to come in at your sales price, also very important.

Lynn McGeein · Answer

Sorry, not sure I understand your question.  There is never a way to insure a property will always appreciate, improvements or not, if that is what you are asking. There are many underwater borrowers right now who purchased property never thinking it would be $100,000 less the next year, but it was.  Any property is only worth what someone will pay for it, and you never know what would happen.   The surest way to insure value is to buy right in a growth area so you can make good money on monthly rentals whether or not the property steadily appreciates in value, and have enough of an emergency fund to not ever have to sell unless you want to.

Matt M. · Answer

Thanks Al! I've seen your posts around and noticed you tend to give good advice. I dont believe I have seen your blog though, so I am going to check that out right now.

I am feeling very confident of looking for my first property, and am more excited than I've probably ever been about anything.

Matt M. · Answer

The main catch of my desire for multi rentals is the fact that IF there is nobody else living there, I make enough to maintain my "monthly rent" to the bank; I have a place to call home where I'M the boss; and i could potentially make money in the future if I have to sell off. The area's I'm looking in c ertainly do have demand; I dont think that will be much of an issue, especially after I mold this place into the apartment I envision.

Jon Holdman · Answer

Matt M in your other post you said you could buy a four plex for $60-100K.  How much rehab do you expect that to need?  What rents do you expect to get?

IMHO, there are three factors to consider when buying a rental:
1) Does it make money?  Is (50%*rent)-P&I a positive number?  Is that number divided by your investment a big enough percentage?
2) Is there demand?  If you can't keep it full without resorting to bad tenants or steep discounts, you can't make money.
3) Do you have some equity?  Even if you don't plan to sell, you want to give yourself an out if you're forced to sell.  When you sell, you lose 10% of the sales price for costs and commissions.  So, if you have less than that amount of equity, you'll have to bring cash to the table to sell.

I know you're talking about starting with multi-units, but SFRs are easier to buy and sell.  If you're new to this, you may discover you hate being a landlord.  Dumping a few SFRs is easier than a single fourplex.

Matt M. · Answer

Lynn- those are my thoughts as well, saving that money in the bank if I can get a loan with no/minimal downpayment. I'd much rather have it "incase".

Jon- with the price I can pick these rentals up for, I could live by myself for all eternity in them and not worry about a renter coming in to pay my note. Does that mean I want to? Hell no... I'm doing this to make money, not have a large useless property sitting around. BUT, with that being said, since the monthly principle will be so low on the properties I'm looking at, its terribly easy to break-even, thus being terribly easy to make net income.

Jon Holdman · Answer

First, for rentals you need a good handle on the true expenses.  New investors get caught up in the "cash flow = rent - PITI" myth.  That is just not true.  You have many other expenses.  Read about the 50% rule, which says 50% of your gross rents go toward expenses (money you spend in one year that the IRS lets you deduct in that year), capital (money you spend in one year but that must be depreciated over several), and vacancy (rent you never collect, either because the property is vacant or you've given some sort of discount.)  From the remaining 50% you have to pay your debt service.  What's left is your cash flow.  Lenders use a rule of thumb that says "net rental income =  (75%*rent) - PITI", which is slightly more optimistic.

Now, the 50% rule assumes you're paying for a property manager.  They typically take 10% of collected rents and half a month's rent to fill a vacancy.  At one vacancy per year, that's a total of about 15% of your annual rent.  So, a solid third of the 50% is for the PM.  If you self manage, you can earn that money.  But it is a job.  Many months its nothing more than collecting the rent.  But some months it will be dealing with a turnover.   I figure a solid 10 hours work at a minimum for a turnover, maybe as much as 20.

If you're living in one of the units, that slightly reduces your expenses (I presume you won't wreck the place :-)), but it takes away a chunk of your rent.

I don't give you then numbers to discourage you, but to help you understand the reality.  Any particular property in any particular year will vary from this benchmark, perhaps dramatically.  But for a portfolio of properties over the long term, this appears to hold up well.

I'm a bit confused by your "appreciation" question.  There are really two forms of appreciation.  One is just overall housing value appreciation. Historically, this has roughly matched inflation (based on Case-Shiller data that goes back to the late 1800's.)  During the bubble, it was dramatically higher.  During the burst, its been dramatically worse.  Your guess is as good as mine as to what it will be in the future.  I do not factor this into any analysis because any number you choose is just a guess.

The other form of appreciation is forced appreciation.  If you buy a junker and fix it up, it will certainly be worth more.  If you buy pretty nice house and make some improvements, the increase will be less on a percentage basis.  When fix and flipping, you want to improve the house to match others in the same area.  When fixing to rent, you want to make it comparable to other rentals in the same area.  For rentals, you want it to be sturdy.  A rental fixup is a different thing than a retail sale fixup.  If you do the retail fixup on your rental, you'll be wasting money because, over time, that stuff will be damaged and have to be redone.  OTOH, you don't want your house to be a dumpy rental, either.  Its best to have a look at other properties in the same area and see what they look like.  You can often do this when you've viewing potential properties to buy.  If you're buying in a rental area, many of the properties you view will be rented.  Just observe what they're like.  Ask the tenants what they're paying for rent.

It is VERY easy to go overboard.  Whether fixing for rental or sale, you have to be careful to ignore what YOU want.  Instead, focus on what your market wants.   Do enough, but no more, to match the market's expectations.

Lynn McGeein · Answer

Matt, my first instinct with rates this low is, if you can buy owner-occupied right now at low rates for little cost, put as little down as possible.  It will be very difficult in the future to ever get low-down options once you have your first property as they are getting much more stringent on proving owner occupied status if you have other property.  Unless the 30K is a drop in the bucket in your reserves and it's just going to sit there earning you nothing, anyway, I'd hold on to as much as I could for future emergencies or your next investment property.

Matt M. · Answer

What excellent replies! Thanks a ton guys.

so is it wise to try and get the entire property funded by the loan, or is it wise to lose my $30k to downpayment/repairs/etc? If I can find a home for <$100k, I will have a 30yr note paid off in a good 5years with the prices I can bring in on said rentals.

How do you "appreciate" your rental property?

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