Rent by the Room Approach and How that Affects Appraisal

[Lauren Cutchen]

I am looking to purchase a single family home and turn it into a rent-by-the-room situation. PadSplit is suggesting to take away common spaces like the living room and dining room and turn them into bedrooms. I think this is an interesting concept, ran the numbers, chatted with the company, and it all seems good so far. I've identified a property that I can comfortably do this with. I need to install hard flooring throughout (probably vinyl), paint, and put up walls in a few rooms turning this 3300 sq ft, 4 bed, 3 bath house into a 9 bed, 3 bath house. I also need to expand and create access for parking. 

My question is the best way to finance this property. I do not qualify for a traditional loan...yet. Our goal would be to eventually refinance and take some money out for another project. So I have questions about the appraisal. 

Details: 

Purchase price $250,000

ARV (assuming cosmetic updates only) $300,000 - not a great ARV

Traditional Rent $1500/month - it was a rental house for years 

Rent by the Room @ $150/week (1 month min) $5400  - assuming fully occupied and before padsplit fees, expenses...

Cash flow: $2500/month

Estimating $50k for rehab - extremely conservative and we plan to frame and do the drywall, and painting ourselves. Large house = large budget. I'd prefer to finance construction costs, but can do this out of pocket if we needed to. 

1) Hard Money Loan - I would need to refinance after construction costs and updates. How will this kind of property be appraised considering we eliminated a living room, dining room, and bonus room? Would we refinance this into a commercial loan? 

2) My MIL is willing to finance this with 20% down and do an investment loan. Could we roll this over into an LLC or refinance into an LLC? I don't mind having a partner with this project, but I want part ownership of the property.

3) See if a bank wants to keep this in house? Would I show them a business plan for this project? I've contacted 2 banks that have said no. 

How would this property appraise after construction? I want to put an offer in ASAP. I prefer to do this myself without the help of my family. And if we did go the family route, what's the best structure for that? 

[Joe Splitrock]

@Lauren Cutchen you better check with the city regarding zoning and occupancy laws. You are taking a single family home that would normally have 2-3 cars and you are going to have 9 cars to deal with now, so parking spots will be a big issue. This also puts substantial wear on the bathrooms and plumbing system. A typical water heater may support 3-4 adults, so you will need to add another water heater. You will need 2-3 refrigerators so people have a place to store food. There are also potentially insurance and fire safety concerns. Make sure every bedroom has sufficient square feet, closets and fire egress offering two escape routes (window outside and door).

As far as appraisal, odds are good that the modifications will reduce value. There is far less demand for 9 bedroom houses without dining or living rooms, than there is for 4 bedroom normal houses. The appraiser may also use the income approach for valuation, but since it is single family, the primary valuation will be based on comparable single family home properties. 

This could be difficult to finance through a bank. This is going to be a lot of work to manage, so be prepared. You are not going to have 9 people sharing a space without conflict. I would also hire a cleaning company to come in once per week to clean the kitchen and bathrooms. Lots to consider here. Don't get starry eyed by the cash flow and forget all the other details.