Would You Do This Deal? NC Vacation Rental (Outer Banks)

[Troy Hebert]

Hi all,

I am finally buying my first property. It's a SFH under contract right now for $1.1mm. In the Outer Banks in North Carolina (Corolla specifically).

I've posted here before where I've looked in various regions of the country, namely CT, NY, NJ, FL, AZ, and have had real difficulty finding a good "turn key" rental property that actually produces real cash flow (after actually factoring things like capex, etc.) What I ultimately arrive at is that assuming no property price appreciation, the returns are typically 4-6% IRR unless I go class D or look at other deals that require significant owner involvement. At that point, I've just said why not buy REIT's and get similar returns and have the liquidity. It all seems to be speculation based on the price appreciation, which I haven't been comfortable with.

I do co-invest in a large real estate PE fund that focuses on value-add multi-family and other similar projects, but those are an entirely different ball game. Returns are pretty strong there with that firm, but I also want to own a property myself.

Anyways, a family member of mine invested in a SFH in the outer banks, ocean front. He is getting some crazy rental numbers from May-September, and he has a good amount of real estate rental experience in various parts of the country. He believes the area is one of the few areas on the ocean that you can still buy "cheap" (this is relative, say $1mm on the ocean for a nice 7BR house) and is growing and gaining more awareness. They rent well, and he actually likes to vacation there.

So I've looked at quite a few in person and modeled out probably 25 properties, and most don't work great. But there are actually quite a few. I currently have one under contract that seems pretty solid, but I may be missing something.

It's a 7.5% cap rate, and this is Class A (Class A plus if it existed). So that alone is pretty exciting. $1.1mm purchase price on $140k of 2020 bookings / $75k of annual NOI (including $8k of capex spend/reserves). I have the option to do a 10% down no-PMI loan at 3.51% blended rate. Throws off $1,900/month in FCF after paying down the full mortgage/P&I. It is a 10BR/10.5BA, 3 story house with ocean views, 2 lots off the ocean. Maybe 10 min walk to the beach, pool, elevator, movie theater room, etc. The story on it is that is was (one of the very few) properties that went into foreclosure last year, and the existing owners picked it up at $720k. They put $150k into the property, are collecting the rents for the season, and exiting. Good return for them. I saw it personally and it was clearly the best looking property we looked at. The dynamics, I was told by my agents, are that in the area investors look at the 10% rule, where you want 10% rents/purchase price. That seems to be the sweet spot for the area to get real cash flow after the mortgage. This one is 12.7%.

Property management is 11% and they are a traditional on-site manager with 300 houses on the island and have done very well with this one. A lot of managers here have not evolved and do not use any of the online booking sites. This manager does, and just handles a mix of traditional bookings and VRBO. The manager tells me he doesnt believe there will be a lot of volatility with the rents, he thinks it could do $133k for example one year, but he said at the same time you'll probably do $150k down the road. That is definitely a huge risk, just given this one does so much more in rental revenue than any of the other ones I look at. I fear it gets normalized compared to other properties.

Insurance diligence is ongoing, but the hazard insurance is ~$7k a year and covers loss of rental income. Lots of wind and hurricane risk in the area. In an X flood zone, which is good, but still requires flood insurance. All of that is factored into prior and current expenses.

New metal roof, new water and pool heaters, new furniture and TV's, etc. So I modeled $8k/year in Capex / repairs & maintenance. Management thinks $5k would be OK, but will vary.

Overall, IRR is 23% assuming I sell it at $1.1mm, what I entered at. If I sold for $930k, in 5 years, that is my break even point by which I lose money. But I have to think that a house like that on the water that is doing $140k in rental revenue during a 20% unemployment economy and a pandemic, should hold its value or even sell for more.

This is my first one, so I apologize for the length. Any advice would be greatly appreciated, and I'm happy to return some help as well (I can send folks my model to use if that helps in their analysis, for example. I was a prior investment banker, private equity and corporate credit person so I spent a lot of my junior years in finance modeling).

[Troy Hebert]

Originally posted by @Daniel Alvarez:

@Troy Hebert I’m with you on the analysis. Also your customer base should be more resilient to a downturn —and assuming your $24k is FCF, that plus any reserves should be a decent buffer in a downside case.

It feels you have a solid deal, too solid to walk away from. I always say if it’s not nerve wrecking then I’m missing something. You should check with your insurance agent, you may have a full replacement value coverage but even then I’m not sure your equity wouldn’t be wiped out after paying debtors.

I suppose the other option is to wait for a dip in the next six to nine months... but then of course prices may not dip. As I read from experienced investors in the forums, you make a move if the numbers make sense for you now.

One aspect that confounds me still with seasonal rentals is the fact that property prices tend to be higher in Spring-Summer months and lower in Fall-Winter —as in many markets, where seasonality can move house prices 5-10%. However, and especially in OBX, if you close in the summer you will incur expenses for 9 months until the big cash flows come in (maybe less if big on prepayments), which means more cash reserves. As you know timing of cash is big for IRRs. Combined with lower demand and lower prices, buying in the winter would make all that much more sense on paper. Risk of waiting until winter is of course prices not coming down, short supply, cash on hand not earning returns, etc. Just curious if winter prices really account for the potential $50-100k+ income coming around the corner...

So the $24k includes $7500-$8k in annual capex spend. If I don’t spend it, it builds into reserves. Property manager thinks $5k max. I think it’s reasonable.

On seasonality, yes definitely an issue. I had to rebuild my model to be monthly. I go line by line and allocate a % of full year expense to each month. Ie linen and turnover expense is tied directly to weeks rented. Capex spend occurs in off season. Etc.

I show a negative cash balance of about $25k in May going into the season next year. I hadn't factored in deposits, which is interesting and definitely a real factor that should be considered. My cousin who purchased an ocean front property down the road told me that folks pay 50% of it up front in advance, and some are booking the week after their stay for the next year. But the monthly model definitely shows large fluctuations MoM in cash balance. IRR pretty significantly impacted, if sold in the short-mid term, depending on the month. But I do believe I could sell it for $50k more going into the season (70% of NOI) in a base case that would offset the expenses incurred during the off season (net of the incremental 5% broker fees on the $50k).

One thing with this one as well that’s super important. The property manager doesn’t have any reviews on it. It was purchased out of foreclosure in November last year for $720k. They put $200k into it, have rented it out for the season at an impressive $140k, and seem to be flipping it for a nice profit. Can’t help but feel I’m the bag holder buying it at the top. But at the same time, it has the best numbers out of any that I looked at and I got them to come down from $1.2 to $1.1mm. I assume because they are still making a great return. But there’s no historical data besides 2020 with this one given the history. Also, I haven’t been able to get an answer to the question as to who defaults / forecloses on a property that’s capable of cash flowing so much? Why wouldn’t you just hold? I don’t know.