0% cashflow for 3-4 years

[Jonathan Bombaci]

I am working on a deal. 12 units in 2 buildings in northern NH for $380k with $60k coming back to me at closing, net price of $320k. I structured it that way to reduce my cash outlay to less than $25k. The property grosses $100,800 today after expenses, pm fee, vacancies, and debt service it should cashflow $25-$30k a year with +15% cap. It was looking like an incredible off market deal. However during inspection we found $100k worth of major repairs ($35k furnaces, $30k electrical, $15k roof, $10k fire escape, $10k sewer pump). If I put the $100k into the price it reduces the cap to 9.2%. I see mostly 5-8% caps on the market in the area. 

So it makes sense on paper but I don’t have $100k to do those repairs which is why the offer was the way it was. I’m thinking of spreading the repairs out over 3-4 years and reinvesting the rents into the repairs. So I’d have 0% return until year 5 but then get 100% of my Money ($25k) in 1 year and then profit from there. 

Does this make sense? I really like the property and this would bring me to 24 units in the area. I’m excited to see the benefits of scale. But I also see this as potentially writing checks my *** can’t cash... what do you think? 

[Matt Lefebvre]

@Jonathan Bombaci properties will oftentimes have upfront capital expenditures that need to be taken care of that don't necessarily add a substantial amount to the bottomline.  You should be measuring this property by a few different metrics.  For example, you've already analyzed the cap rate difference from $320,000 to $420,000 because of the capital items you have to spend money on... this has compressed your cap rate from 15% to 9%.  

What is the difference in your cash-on-cash return? If you were initially pulling a $25,000 annual profit from the property based off of a $95,000 downpayment (or a $35,000 downpayment + $10,000 closing costs so a $45,000 cash-in because of the credit) then you were looking at a ROI of 55%. That's a fantastic number! However, because you have $100K of capital items looming, assume you fund your capital reserve by $100,000 in year one (for simple math). That means your upfront cash-in is now $145,000 rather than $45,000. Comparing this to your $25,000 annual cash flow, that means your ROI is now 17%; which is certainly not a bad number.

You don't have the cash in your bank account to invest $100K upfront though. Which means your "cash-in" costs might be $45,000, and the $25,000 profit needs to be invested into your capital reserve fund every single year. So your ROI drops to 0% for 4 years. Assuming all of these pending repairs can actually wait for up to 4 years without penalty or failure, that puts your breakeven point at the end of Year 6... which translates to an IRR of 13%... a little low considering the amount of time you have to wait to get your money back, but not the end of the world.

The above assumptions are also independent of the fact that in addition to spend $100,000 in capital items over the next 4 years, you still have other capital items that will creep up during that time.  You still have to fund your capital reserve account at a normal rate so you don't get stuck in this situation again 10 years down the road.

In summary, does this make sense?  That depends.  

If your target exit date is 5 years, absolutely not... you're still in the red.  

If your target exit date is 10 years?  Maybe... since you have recouped your investment and have had a few years of good profit... but you have to be okay knowing that you're doing a bunch of work for NO money for 5 years

If your target exit date is 20 years?  Still maybe... because you haven't defined the condition of any other capital items that will come up and what your desired return is.

You can't rely upon appreciation in Northern NH, so you might be stuck holding onto this one for the long term if you want to try and sell it for more than you bought it for plus all of the money you spent on it.