Breaking rules on first deal

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Breaking rules on first deal

Jeff Holmberg
Member since 2021 · 4 posts · 3 votes

After years of reading books on real estate (most recently by David Greene and Brandon Turner), I'm finally getting started!  Unfortunately, I think I need to break some cardinal rules in order to get into the game. But before I do, I'm hoping to explain the situation and see if more seasoned investors here think I'm being wise or foolish.

I live in the upper Midwest, and I feel like there's a lot of potential to buy properties that fit my criteria in Minneapolis and Des Moines. The most relevant criteria for this post include: bad homes in good neighborhoods, high comps compared to my property, and "all in" cost at <80% of ARV. However, Minneapolis and Des Moines are highly priced compared to surrounding small towns (as much as 10x more expensive). Since I'm sure I'll make a lot of mistakes in my first couple properties, I've decided I'll feel more comfortable starting out my real estate journey in smaller towns (around 25,000 people) with low-cost property, in the $25k to $75k range. After a few years of growing my experience and my capital, I'll feel more comfortable entering larger markets and taking on bigger risks.

In the meantime: I'm finding that these smaller towns don't have rental property that meet my criteria.  Instead of buying a bad house in a good neighborhood, I'd be buying (or rehabbing) a good house in a bad neighborhood.  Not bad like crime-ridden; just bad like: low prices, dilapidated homes, near business districts, etc.  Given the high demand / low supply, sellers of rental property are asking for a lot more than surrounding homes sell for. 

Quick example: I could buy a duplex for $70k with enough cash flow to make me feel good about that price. But the appraisal might come in around $30k-$40k based on surrounding homes, so I'd seek seller financing for the difference. I would likely treat the duplex as a long-term investment, focus on the cash flow, and disregard the fact that it's supposedly worth less than what I paid for it. If my models hold true, my long-term ROI could still be great at around 12%/year. But even if my models are wrong and I end up with lower returns (or even a loss), then at least I'm getting experience with low risk like I wanted.

Am I being penny wise and pound foolish?  Or am I being wise by starting with very little weight on the bar, and only adding weight as I get stronger?

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Jon KellyPro Member
Investor · Bethlehem, PA · Member since 2016 · 929 posts · 951 votes
5y

@Jeff Holmberg I think you raise two different points. 1. Investing in smaller towns and 2. buying a duplex for $70k with an appraisal value of $30-40k. 

On the first point: I've had a great experience investing in smaller towns. For me, the decision to invest in smaller towns was not about taking smaller risks and more about the financials. You can find a $30-40k property that will rent for $600-700/mo. Keep in mind you should expect higher vacancy rates and higher repairs due to the age of the property and tenant class. I would highly suggest finding a property management company in your area to manage the properties. 

On the second point: If you bought a property for $70k why would it appraise for $30-40k? Seems silly to purchase if you're losing 30-40k in value immediately after closing. I would discuss comparables and property values with an agent to make sure you're comfortable with the ARV on properties you are analyzing.

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  • Jon KellyPro Member
    Investor · Bethlehem, PA · Member since 2016 · 929 posts · 951 votes
    5y

    @Jeff Holmberg I think you raise two different points. 1. Investing in smaller towns and 2. buying a duplex for $70k with an appraisal value of $30-40k. 

    On the first point: I've had a great experience investing in smaller towns. For me, the decision to invest in smaller towns was not about taking smaller risks and more about the financials. You can find a $30-40k property that will rent for $600-700/mo. Keep in mind you should expect higher vacancy rates and higher repairs due to the age of the property and tenant class. I would highly suggest finding a property management company in your area to manage the properties. 

    On the second point: If you bought a property for $70k why would it appraise for $30-40k? Seems silly to purchase if you're losing 30-40k in value immediately after closing. I would discuss comparables and property values with an agent to make sure you're comfortable with the ARV on properties you are analyzing.

    4Reply
  • Corey Hawkinson
    Rental Property Investor · Bloomington, MN · Member since 2019 · 404 posts · 542 votes
    5y

    @Jeff Holmberg I agree with Jon. I’ve had success in smaller towns. For me, that includes investing 30 minutes outside Minneapolis instead of in Minneapolis. The numbers have been much better in those areas. I’m above the 1% rule there and I don’t think I could be above 1% in any part of Minneapolis where I would want to be at night.

    0Reply
  • Tim SwierczekPro Member
    Lender · White Bear Township, MN · Member since 2016 · 1k+ posts · 1k+ votes
    5y

    @Jeff Holmberg First, thank you for laying out your situation well, and I applaud you for asking if you are being penny-wise & a pound foolish.  I think the short answer is yes.  It's a really bad idea to pay approximately 2X the current value on a property.  Remember price is only one factor in the equation, revenue, and R&M costs, along with long-term appreciation, rental, and sale demand are all factors.  Consumers think price, business owners think profit.  A business owner would never do this deal because the cash flow even if it's $300/month will take about 10 years to pay back the price difference once you factor the interest paid to the seller.  This means you are not at all profiting on CF for the first decade. 

    Your comment about building up experience and capital before you take on more risk is backward.  If you do this deal you are taking an immense risk.  At $600-700, a month in rents there can't be too much CF, I'm going to assume no more than $300/month or $3600/year.  The cost of repairs & maintenance is not lower on a low-value home than on a high-value home.  The water heater, toilet, per window cost, paint, carpet all cost the same as a house in the cities, and this is especially true as you have described these properties as needing work. Over time I expect the R&M will eat away your CF, but even if it doesn't you are one non-paying tenant and or a significant repair away from needing to sell yet you will owe 2X the actual value.  I really can't think of a more risky deal than this one.  Lot's of risk and very little reward.  

    On the flip side, metro-based investments in Minneapolis/St Paul are doing wonderful.  It takes some work to find them but the cash flow should be more meaningful and they sell in 1-7 days, without the need to sell it on seller financing to offload it.  I do not recommend you overpay to take on someone else's problem.  If you can swing it I believe you will be much better off purchasing a 300K-400K duplex in MSP than a 30K-40K duplex in a small town as you described.  Feel free to PM me and we can talk about it.  

    2Reply
  • Marc RiceBusiness Member
    Real Estate Agent · Columbus Cleveland Dayton, OH · Member since 2018 · 2k+ posts · 1k+ votes
    5y

    You won't become a millionaire on your first deal, or your second. The best deal is the deal that gets you started and your wheels turning. If the right opportunity presents itself as a decent deal in a good neighborhood, buy it!

    [email protected]614-363-2787
    Marc Rice | Investor Friendly Agent at Reafco Tailwind Team574 Reviews
    WebsiteView Page
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  • Darson GranthamBusiness Member
    Realtor · Des Moines · Member since 2018 · 304 posts · 253 votes
    5y

    @Jeff Holmberg, I personally LOVE the fact that you are evaluating small vs big city investing.  I think that you are making one big mistake in your logic.  You are assuming that higher prices means higher risk.  (assuming that 25K for a run-down house in small town is less risky than $75K for a run-down house in a large city.  When in reality, if you know what comparables are, and they are equal, the risk is the same, you are just getting a larger loan or using more of your money in the larger city.  In a small town, you should be able to hit the 2% rule in my experience, fairly easily as a rental.  If all you can find is a 70K duplex that would be appraised at 40K, you should keep looking because you'll find an owner that will sell for appraised, you just need to look harder. IMO.  I have properties in small towns and in Des Moines and there are pros and cons to both strategies!  Good luck!

    [email protected]515-612-6013
    2Reply
  • Jeff Holmberg
    OP
    Member since 2021 · 4 posts · 3 votes
    5y

    Thank you everyone for your feedback! I really appreciate you taking the time to help me out. Here are some of my key takeaways from your comments:

    1.) Although I hope to make this a long-term buy/hold investment, I need to keep my options open for selling it earlier than planned, due to some unforeseen repair, vacancy, etc.  To the extent I overpay for the property, I will lose money in the event of this unplanned sale.

    2.) I should look harder for property that I don't have to pay higher than appraised value for.  I admit I've only looked hard in two cities.  There's a lot more cities to look at!

    3.) Just because a property costs less doesn't mean it's less risky, because the probability of it becoming a bad investment isn't any lower. 

    I will likely reach out to some of you to learn more about your lending / realtor services. Thanks again!

    1Reply
  • Noah Chappell
    Investor · Minneapolis, MN · Member since 2016 · 254 posts · 228 votes
    5y

    @Jeff Holmberg sounds like you've doing a lot of great research, and are just at that point where the theory needs to become practice for you to progress in your learning. Don't over think things, just stick to the fundamentals. If you're planning on buy and hold, aim for a great investment in a great market from the beginning, and only plan to sell if you find a better return on equity and can 1031 out. No matter the scale, the number always need to work, whether it's a highly priced hot market like Minneapolis or a small town. If you're looking in MN, I'd suggest a strong more peripheral market like St Cloud for ex where you can find a decent duplex needing some cosmetic work for around 100-120k, fix it, refinance out. To do that in Minneapolis - St Paul right now admittedly you need very strong local knowledge and a good network. When it comes down to it, you just need to jump in keeping in mind the fundamentals, and your understanding will blossom from there.  

    2Reply
  • James Hamling
    Real Estate Broker · Minneapolis, MN · Member since 2011 · 5k+ posts · 6k+ votes
    5y

    @Jeff Holmberg

    At the start you had me applauding; recognizing your weakness and risk exposure in the market and turning that into the opportunity potential of looking at ancillary micro-markets. 

    And then you had to go and start over complicating things and pre-selling how losses are ok, no, there not, a loss is a loss and it's no bueno, don't lie to yourself. Look, keep it simple, it dosn't need to be complicated; you make $ when you buy, just stop there and focus there. Either you can make a profitable buy, or not, no madder how hard you squeeze a rock you won't get juice. 

    The reason why Twin Cities are so competitive are exactly why you'll experience low to no competition in those rural areas, use that leverage, lean into it. 

    Property management will be your biggest logistical headache, so plan that out from start. In rural areas your gonna have to rub elbows, make friends, connect, it won't happen over night. Maybe check in with cities asking about abandoned properties, you'd be surprised at how many actually exist. Find those remote lake areas and take a drive around looking for the old run down shack. Your advantage is the deals are too far and few between for the volume based operations, but you don't need volume, so go for quality. 

    0Reply
  • Jeff Holmberg
    OP
    Member since 2021 · 4 posts · 3 votes
    5y

    @Noah Chappell

    @James Hamling

    Thanks for the ideas! I really appreciate your time, and I now agree that overpaying for real estate is never justified. I’m working with an investment-minded realtor now to look harder for good deals.

    0Reply
  • Anthony Vicino
    Investor · Minneapolis, MN · Member since 2017 · 95 posts · 130 votes
    5y

    I generally agree with you @James Hamling , but I want to push on the concept that you "make money when you buy".

    Technically all you've done at purchase is drop a bunch of money and take on even more debt for the opportunity to make money by successfully executing the business plan in the coming months and years.

    Too many new investors jump into the game thinking they just have to "buy right", and they completely overlook the "execution" phase and how difficult that can be.

    You're dead-on in the assessment that @Jeff Holmberg is going to make things more difficult than necessary by seeking out sub-par assets in sub-par markets.

    Jeff, we get the urge to just do a deal, but Buffet's rules of investing (rule number one: don't lose money. rule number two: don't forget rule number one) are critically important.

    Don't buy a negatively cashflowing asset as a new investor. You're setting yourself up for trauma.

    Also, think long and hard about your exit strategy. There's a reason $70k duplexes in the sticks are selling for that.. it's because the cash flow is poor and they're in a low-demand area.

    Sure, you can find a cheap deal out there because there's not a lot of competition, but it's that very lack of competition that makes these assets incredibly difficult to dispose of when you're ready to cash out.

    0Reply
  • Jeff Holmberg
    OP
    Member since 2021 · 4 posts · 3 votes
    5y

    @Anthony Vicino

    Thanks for the words of wisdom! I’ve since secured access to more financing, which will help me shift my focus to larger markets like the Twin Cities or Rochester. This should help give me more opportunities to pick from, and make it easier to sell when the time comes.

    Just throwing this out there to you and everyone else who has weighed in on this thread, I’d love to buy you lunch (via DoorDash if you’re far away) and hear your stories about how you got started and things you’ve learned,

    Jeff

    0Reply
  • Anthony Vicino
    Investor · Minneapolis, MN · Member since 2017 · 95 posts · 130 votes
    5y

    That's awesome to hear, Jeff! I'm in Minneapolis. Shoot me a DM and we'll set up a lunch!

    0Reply
  • James Hamling
    Real Estate Broker · Minneapolis, MN · Member since 2011 · 5k+ posts · 6k+ votes
    5y
    Originally posted by @Anthony Vicino:

    I generally agree with you @James Hamling , but I want to push on the concept that you "make money when you buy".

    Technically all you've done at purchase is drop a bunch of money and take on even more debt for the opportunity to make money by successfully executing the business plan in the coming months and years.

    Too many new investors jump into the game thinking they just have to "buy right", and they completely overlook the "execution" phase and how difficult that can be.

    You're dead-on in the assessment that @Jeff Holmberg is going to make things more difficult than necessary by seeking out sub-par assets in sub-par markets.

    Jeff, we get the urge to just do a deal, but Buffet's rules of investing (rule number one: don't lose money. rule number two: don't forget rule number one) are critically important.

    Don't buy a negatively cashflowing asset as a new investor. You're setting yourself up for trauma.

    Also, think long and hard about your exit strategy. There's a reason $70k duplexes in the sticks are selling for that.. it's because the cash flow is poor and they're in a low-demand area.

    Sure, you can find a cheap deal out there because there's not a lot of competition, but it's that very lack of competition that makes these assets incredibly difficult to dispose of when you're ready to cash out.

    I simply don't agree on many levels. 

    First speaking to rural investing. If rural investing were so bad due to lower population density, explain why Trailer Parks, a vastly rural product, is "The" gold standard of COC real estate investing?

    Additionally, I personally know of some rural specialized investors absolutely killing it who think anyone who invests in a town of 7K+ population is absolutely nuts because they won't even bother to look at anything one penny under 20% ROI.

    Rural investing is neither "golden fields a-plenty" nor is it a "barren-waste-land", it's both, either, neither, all depending on what market areas, demographics, how you operate and a host of other factors. To declare it as horrible off bat is flat wrong and not true. 

    So many novice investors are going into popular markets and just throwing $ at properties, ESPECIALLY multi's, because that's where they think they have to be, it just isn't so. Nearly ever town on earth needs rentals, including the 2,500 population density towns. Is rents lower, absolutely, so is purchase price, tax's, often times regulations are much less, vendor pricing is a savings, AND competition is ultra low with most often better tenant class as well usually. For a newer investor, to get in at a low risk point, I applaud rural investing, it's smart risk mitigation. 

    Remember, not everyone is all gung-ho about making a million dollars on every deal, many are just happy to make a simple return, walking the get-rich-slow program. Cutting one's teeth in low cost rural can be a great proving ground to learn the skills and experience for future major market investing where prices, stakes and risk are much higher. 

    0Reply
  • Anthony Vicino
    Investor · Minneapolis, MN · Member since 2017 · 95 posts · 130 votes
    5y

    I don't disagree in principle, @James Hamling, there are certainly great micro-rural markets with some decent deals, but in application that's not exactly the situation Jeff was presenting.

    Jeff is talking about picking up a duplex that'll appraise for $30-40k. That suggests a real rough market, which is why I specified "sub-par assets in sub-par markets".

    Are there great rural markets? Absolutely?

    Is the one Jeff's looking at one of those? Me thinks not.

    On the mobile home park front, it's a bit unfair to compare a MHP with a duplex.

    Sure, they might both be in rural areas, but the MHP has benefit of scale coupled with incredibly low overhead. This is why it's the kind of CoC.

    Again, there's nothing wrong with buying in a rural market, but the question all investors must answer before walking into a deal is: How are we exiting this thing?

    As the illustrious Bill Hamm recounts his flight school instructor's lesson: "Takeoffs are optional. Landings are mandatory."

    The fact that there's no competition in acquiring the asset might suggest there's going to be no competition when it comes time to sell.

    Could be problematic.

    0Reply
  • James Hamling
    Real Estate Broker · Minneapolis, MN · Member since 2011 · 5k+ posts · 6k+ votes
    5y
    Originally posted by @Anthony Vicino:

    I don't disagree in principle, @James Hamling, there are certainly great micro-rural markets with some decent deals, but in application that's not exactly the situation Jeff was presenting.

    Jeff is talking about picking up a duplex that'll appraise for $30-40k. That suggests a real rough market, which is why I specified "sub-par assets in sub-par markets".

    Are there great rural markets? Absolutely?

    Is the one Jeff's looking at one of those? Me thinks not.

    On the mobile home park front, it's a bit unfair to compare a MHP with a duplex.

    Sure, they might both be in rural areas, but the MHP has benefit of scale coupled with incredibly low overhead. This is why it's the kind of CoC.

    Again, there's nothing wrong with buying in a rural market, but the question all investors must answer before walking into a deal is: How are we exiting this thing?

    As the illustrious Bill Hamm recounts his flight school instructor's lesson: "Takeoffs are optional. Landings are mandatory."

    The fact that there's no competition in acquiring the asset might suggest there's going to be no competition when it comes time to sell.

    Could be problematic. 

    I believe we agree on 98% of things and the remaining 2%, is most likely just saying the same thing in different ways. 

    0Reply
  • Anthony Vicino
    Investor · Minneapolis, MN · Member since 2017 · 95 posts · 130 votes
    5y

    A 100% agree with that, @James Hamling!

    0Reply
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