Can I afford the refinanced mortgage payment?

Question

I am considering a wholesale deal on a triplex. It is fully rented with gross rental income currently at 2600 per month. It's a 3bd 1 bath, and an additional 2- tbd/1ba units. The asking price is $253k. One option for value add is an ADU where the current garage and carport are located (900 sq. ft.), Another option is renovating the kitchens and bathrooms. Lastly is finishing the basement (would be an additional 1400 square feet).

I'm leaning toward doing the ADU or the basement. Based on the additional sq footage, the ARV after the ADU would be $487k. Based on the additional sq footage with the basement, the ARV would be around $550k. My concerns are that after refinancing with an ADU, the margin is a little too close for comfort (roughly 40k difference). My problem with the basement is, I'm not sure if the rent, even after being raised, will result in a cash-flowing property.

Knowing that the one-time showing is happening in 24 hours, and offers will be collected right after it, what would be your next steps? Which way would you go, or would you even do the deal at all? I am looking for any guidance. Thank you!

Dan H. · Answer

@Marc Hardy

I know nothing about your market, but here are some general thoughts:

- rent of $2600 is very low for 3 units and a total of 7 BR.  Not sure of the breakdown but 3/1 for $1K and each 2/1 at $800 makes sense.  this price point indicates that the rents have not kept up with CPI.

- Valuation of $253K indicates that valuation has not kept up with inflation.

- At that rent point, this property is cash negative when properly allocating for sustained expenses when financed at a high LTV.

- 3 units have much higher maintenance/cap ex than one unit (not as high as 3 times the maintenance/cap ex but maybe 2.5 times.

- ADUs are not valued the same as the square footage of the primary units.  Search BP for ADU appraisals.  In my high cost RE market ADUs are typically valued no higher than $100K.

- With unit costs as low as $85k on the subject property, what is the value adding an ADU.  It will likely cost more than $85K (or at least close) and you will lose the garage and are not acquiring any land for that cost.

Again I do not know that market but with negative cash flow, rent growth below inflation, and appreciation below inflation I suspect you need a killer value add for this to be worth the effort.  Adding an ADU is not that killer value add.  Is there another value add?

Good luck

Drew Sygit · Answer

@Marc Hardy have you checked the zoning to see if the ADU or basement unit would be allowed?

The cost of additional electric & gas meters for the ADU and basement?What's the cost of installing legal egress access in the basement?

Did you check Zillow to see if any ADU or basement units being advertised or sold and what the rents were?

Chris Barrett · Answer

Great insight Dan! I typically only use cap ex as a measure upon acquisition, or determine if it will be an acquisition. Otherwise I attempt to buy properties that are significantly distressed so replacing everything makes sense within the ARV and ARR(After repair rents) that way the likelihood of major cap ex is less in my expected timeframe of ownership (7 years).

I have a small portfolio, so I don't use cap ex as a measure of reserves for operations.

Chris Barrett · Answer

Hey Dan, what do you underwrite for cap ex/repairs? I underwrite 10% cap ex, 10% property management, then subtract insurance, P&I, then taxes. Personally I management my own properties, so they sit at around a 25% expenses + P&I.

I don't know much about the OPs situation or locale, but I would guess it would make a couple hundred bucks a month? It's not a great buy, I wouldn't do it unless it was in an area where the renovations make it a homerun.

Marc Hardy · Answer

Thanks Chris,

That's what I'm thinking. I'm in Indy but the neighborhood where it wouldn't make sense I feel. But they did let me know the price may be negotiable.

Dan H. · Answer

> With current price and rents you'd definitely make mone

How do you figure this? At that rent point, the 50% rule is aggressive meaning sustaining expenses will be more than 50% or the rent.

Using 50% rule which is too aggressive at rents below $1k/unit at 80% LTV:

$2600 * 0.5 - 1296 (P&i at 6.625%, 30 year)  = $4/month total (all 3 units)

Why do I state 50% rule will be too aggressive at that low rent?  It is because maintenance/cap ex is more a function of the property features than the rent.  Sustaining maintenance/cap ex on a 3 unit property will exceed $900/month (average $300/unit).  a detailed underwriting will depict far worse than $4/month total profit due to the maintenance/cap ex.

This property is cash flow negative at purchase.  In addition rent growth does not show a path to change that because the rent growth historically has not exceeded appreciation by enough to provide a viable path.  The property requires a good/great value add to be a profitable investment (ideally one that can raise rents 50% or more) or interest rates to fall significantly.

best wishes

Dan H. · Answer

Using a percentage of rent is not a good way to allocate maintenance/cap ex.  I recognize many calculators (including the BP calculator) represents maintenance/cap ex as a percentage.  I believe this is a disservice.  I will show by some examples why using a percentage is not a correct approach:

Chris Barrett · Answer

Without knowing more, I'd say not to do an ADU.

However, if both the price and the rents are distressed due to the condition of the property and you could do renovations and get both rents and value up that may be worth it. With current price and rents you'd definitely make money, but is it a money pit with terrible tenants currently?

Marc Hardy · Answer

Thanks Dan!

I didn't know that about ADU square footage not being counted the same. That's helpful.

Can I afford the refinanced mortgage payment?

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