Builder Leaseback good idea?

Question

So we bit off a big one for a first investment! Wife and I just went to contract with a builder on a 2k sqft 4/3 townhome in a resort development in southern Utah. The deal is the builder will lease my unit for at least two years. I think we are overpaying a little bit but it is zoned for nightly rentals and may payoff in the long run. We will finance the 25% down with a loan at 3% from a life insurance policy loan and hope for the best on the conventional investor loan we will have for the purchase money. We plan to try it as a short term rental after the builder is out. Question one is, does this sound like an inherently bad idea to anyone? Question two: I know I should get this put into an entity like an LLC, maybe even Wyoming LLC, but should I spend the money to set this up before I complete the purchase? Obviously, we need to maximize our tax effectiveness in the situation and the monthly is going to be huge, especially if we can't get the rents to cover the mortgage. I considered one exit strategy if this doesn't work after a couple years, which would involve selling fractional shares of the unit while keeping half of them myself in hopes, the sale of the fractional shares would offset the existing mortgage and maybe put us in a winning position. Looking for opinions and input since I'm relatively inexperienced. Thanks.

Matt Ruttenberg · Answer

Nice work on funding the deal with life insurance!  Such a powerful tool when used right.

Michael Baum · Answer

Hey @Greg Teplansky, so why does the builder want the leaseback? Are they going to STR the place?

The LLC isn't necessary IMHO. Just have a good insurance policy specific to STRs.

If you do the LLC, you will need a commercial mortgage which has higher interest and a bigger than 25% down. Transferring the conventional mortgage to the LLC afterward will, in many cases, trigger the due on sale clause which will cause you to go get the commercial mortgage anyways.

The DSCR loan could be an option. It doesn't have any rental history, but seeing as it is in a resort, you might be able to use the surrounding units that are operating (if there are any) to help with the projections.

The leaseback is something I would really want to know about. Is the lease going to cover everything plus some profit?

Personally if it is a loser for 2 years, then it is a bad deal. My 2 cents.

Michael Baum · Answer

Hey @Greg Teplansky, ok so that doesn't sound terrible to me. If you are breaking even at least, that is something.

What I would also want to know is the builder going to deal with replacing all the worn parts when it goes back to you.

IE: painting, carper/flooring, etc etc. I would want that mandatory.

Also, the DSCR might be more attractive seeing as you would have a guaranteed lessee for the 2 years.

What would be the deal breaker on all of this is the mandatory PM. In the end, if what they are projecting is correct, it will be a loser. Like @Sarah Kensinger said, it would be a tough row to hoe once you are in there and it bombs.

Sarah Kensinger · Answer

Your entity set up is right on par...and yes you would set that up before closing. But I few things...The leaseback sounds ok so long as you can cover expenses, sounds like a glorified rental arbitrage without the STR guests. But the HOA insisting on owners using their management company would be a major drawback! I very very rarely hear of anyone happy with a set-up like that and the occupancy is usually around 30% after the first few months. Once the occupancy goes down it's painful to float the property and owners try to sell. 20%-30% management is about normal but if they aren't doing their job, it's hard to lose that much every month.

I would suggest proceeding with caution, you want the freedom to change PM companies if one doesn't work out. Unfortunately, more often than not PM companies are not fulfilling the promises they commit to at the signing of the contract!

Greg Teplansky · Answer

Thank you!

Greg Teplansky · Answer

The tough balance is that the management companies charge 20-30% which will severely limit the positive cash flow. However, they perform all of the concierge services including advertising and booking. So I had to look at it as kind of walking into a ready-made business in a sense and the challenge is more so getting a steady stream of bookings after the builder/renter is out.

Greg Teplansky · Answer

The leaseback was mandatory as this is their first model of their development. That is really what got me interested in this at the price point of the unit. My unit will be one of five units in the same building and the builder will be building  around 60-80 units. This is a sub-development of the larger development/neighborhood area which is basically built to be STR friendly because it is built around a large 2.5 acre man made pool/lagoon. The overall development is a mix of various builders of condos, townhomes, and SFRs. Most of the areas around the lagoon and pool area are zoned for nightly rentals while the remaining areas a little further away are not.  This development is only about three years old so the projections are still subjective. The two on-site hoa approved rental management companies (which must be used if you do STRs with your unit) project around 60% occupancy. I think 40-50% is conservative but somewhere in the neighborhood.

Andrew Steffens · Answer

Im curious is the leaseback mandatory?   What is the STR projection on the unit?

Greg Teplansky · Answer

Thanks for the response. Yes the leaseback will cover the loan and fees for the duration…if we don’t break even, we may have a tiny cash flow.the builder is using it as a model until they sell the remaining units they will build over the next couple years. The leaseback will be $5500/mo… I’m estimating the mortgage around $4700 and they are paying the hoa’s while they’re in.

Builder Leaseback good idea?

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