Over Leveraged? Or smart with Cash?

[Dan Tsunekawa]

Hey BP I wanted to get some opinions on the dangers of over leveraging a property. I am formulating a strategy to acquire a number of properties in the near future using 1 or 2 REPUTABLE turnkey companies(please hold comments on turnkey model, another discussion for another day). I am planning on using conventional 80/20 conventional financing AND using a Heloc against my current home for the down payment + closing costs. I am hoping to buy maybe 5-10 properties in this fashion. If it works i’d like to get another line of credit and keep it going. My end game goal is 20 properties.

Some Facts

• I have a steady job in software that i am not looking to replace or supplement.
• I currently own 2 cash-flowing properties
• I do not need any cash flow today to live on. Any cash returns are put to work expanding my portfolio
• These properties are to set myself up for retirement (I’m 28)
• My heloc terms include P&I on a 30yr schedule. It is not interest only
• Turnkey properties are generally bought close to market value, so no "built-in" equity 
• I am setting aside about $30,000 cash annually for investing

I am in acquisition mode right now, looking for ways to build my portfolio using as little cash as possible. Even tho i am setting aside cash for investing, i am looking to use that for reserves, and stock piling it in for when the market turns back down. I know there are risks associated with being over leveraged. Below i have laid out the ones i can think of and how i am planning on mitigating them.

Up-Keep

• Only use vetted turnkey companies that do solid rehabs
• Save 5% gross rents for maintenance
• Save for capex even tho so many companies tell you it’s not necessary (WHY?! No wait, don’t answer that, i’ll start another thread)

Vacancy

• Buy in markets with strong fundamentals (pop growth, job growth, job diversity)

• Buy in good quality B class neighborhoods that would maintain renters even in a downturn
• Save 5% gross rents for vacancy
• Save for inevitable lease up fees

Rent Prices Drop

• My numbers predict i could stay in the black even with a 10% drop in rental prices (see example below)

Other

• At time of purchase i set aside 6 months of gross rent in cash, for reserves

Sample Property

This is a sample property is actually more like a higher c class, but i you could move the numbers up higher and see the same thing with a B class SFR

Purchase Price: $60,000

Closing costs: $4,000

Rent $900

Vacancy ~ $45(5%)

Maintenance ~ $45(5%)

Capex ~ $125

Op expenses(tax, insurance, lease up, mgmt) ~ $162

NOI ~ $522

Mortgage: $261

Heloc: $68(at current rate) - $160(at highest rate)

Cash flow: $193(at current rate) - $101(at highest rate)

I'm a little scared to ask this, but better burned on BP then in real life, so here we go.

What am i missing or what did i not think of?

[Dan H.]

First I want to commend you on realizing that there is a cap expense and that if you do not attempt to estimate it across every month your not providing an accurate cash flow forecast.  As soon as I rahab a unit the lifespan has started on everything I just replaced.  If I do not take the cost divided by(expected life span in months) starting at the first month I would need to do something like this later on: cost divided by (expected remaining life span in months).  What it would do is artificially make the early months that I included no cap expense look better than reality and it would make the months after including the now inflated cap expense look worse than reality.  You should attempt to estimate the actual cash flow as accurately as you can but realize sometimes that 10 year water heater will last 10 years and a month and other times it may last 20 years (so it is all your best estimate).

A couple/few years ago I filled out a cap expense spreadsheet for my expected lifespans and costs.  My units are in San Diego (one exception) and therefore the costs might be higher but so will some of the life expectancies (virtually no water damage, minimal heat related issues, ... basically a mild climate).  My spreadsheet showed that cap expense here (and I admit I tried to error on conservative) was ~$250/month for a 2/1 attached unit.  Kitchens in San Diego have around $50/month cap expense (a lot to go wrong in a kitchen (refrigerator, stove/oven, garbage disposal, dish washer, plumbing, etc.) and typically need full rehab at 15 to 20 years).  Another way to look at it is spending $7K (today's dollars) rehabbing a kitchen every 15 years provides $7000/(15*12) = $39/month expense.  Granted 15 years is the beginning of my life span time frame for the kitchen rehab  (ideally I want 20 years out of a kitchen rehab) but that $39/month did not include the items that are very likely to not last 15 to 20 years.  Who has a 20 year old refrigerator and if they do are they saving money or losing it due to energy use and repairs?  ditto the dishwasher or garbage disposal.  Maybe you can get 20 years out of a stove/oven but I would not want to rely on it.

Then add in big expenses like roof, foundation, plumbing (whole house re-plumb), electrical (whole house re-wire), hardscape (driveway), windows, etc. on top of the smaller expenses like landscaping, fencing, painting, water heater, flooring (carpet is cheap but does not last - other options cost more but likely result in lower cap expense: We have no carpets in high traffic areas), etc.

I will be surprised if anywhere in this country could have a true expected cap expense of $125/month. My expectations, without actually trying to calculate it, is that it would be challenging to have a cap expense below $200/month anywhere in this country for a detached 2/1 SFR that has a yard.

Therefore your fairly low cash flow estimate I expect is higher than the estimate should be.  If you subtract off at least $75 from the cash flow would it be worth the effort/risk?  That is something only you could answer.

Good luck.