Analysis of a 4-plex rehab with FHA 203k

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Analysis of a 4-plex rehab with FHA 203k

Alex M.
Investor · Philadelphia, PA · Member since 2013 · 185 posts · 97 votes

All,

I'm in the process of purchasing my first property - to both live in and use as an investment. I'm a newbie to this forum - and to investing - and was recommended to post the numbers here. Any assistance with determining if I should move forward or walk away is very much appreciated. I should state that I started down this road prior to ever knowing about BiggerPockets. I found this site while trying to research if I was getting into a good deal or not, and am sooooo thankful I did. Concepts such as cap rate, cash-on-cash, etc are all new to me, as you will see if you read on.

The Property:

Description: Brick Row Home in quickly transitioning (artists, boutiques, cool restaurants, coffee shops, etc all moving in) neighborhood. Good location next to a large city park and public transportation (train), with street to street lot.

Zoning: Currently zoned and used as 5 units.

The Units: 1st floor front studio; 1st floor rear studio; 2nd floor 1-bed; 2nd floor efficiency; 3rd floor 1-bed. In addition, there is a 36x14 large brick garage that could be renovated into a really cool loft-style apartment, or rented out as garage or artist space.

Condition: Poor. New roofs needed for house and garage. All new electric, plumbing, drywall, windows, HVAC systems, etc. Estimated total costs of rehab: ~$150k.

The Price: Original listing price: $224,900. Initial offer: $200,000 w/ 5% seller assist SA). Following inspections and exploration of rehab costs, I revised the offer to $170,000 w/ 5% SA. Seller countered with $190,000 w/ 5% SA, and stated this is firm. My response of $180,000 w/ 5% was rejected, leaving $190,000 w/ 5% as the price to take or walk from.

The Plan:

Use FHA 203k financing to put 3.5% down (cost of purchase and cost of improvements rolled into one loan). Rehab entire property to make 4 very nice newly-finished apartments: 3 very open attractive studios (1 with a deck), and 1 bi-level 1-bedroom in the back (FHA financing requires reducing the property to 4 units max). Refinance property on completion and reduce mortgage costs, and/or extract a little equity to apply to next property. Down the road, restore the garage into a loft-style apartment and add that to the rent roll.

The Numbers:

Cost Assumptions

As can be seen above, there are a lot of add-on costs for financing with FHA. In particular, it assumes a 6-month rehab period with mortgage payments rolled into the loan, as well as a 10% contingency reserve for cost overruns. If I can manage these (time and overruns) then I get to roll these fees back into the principal.

Finance Assumptions

In looking at some of the investment criteria I've found on BP, I needed to make an estimate of ARV - I've used a little over 110% of the total property cost (purchase plus rehab) to approximate this. Also important to note is that I have taxes and insurance included in mortgage payment so as to keep the calcs simple - these values came from lender GFE.

Rental Income

I'm estimating potential rental income from my girlfriend who works for a property management firm and rents similar properties on a daily basis. I've currently assumed a 10% vacancy rate. I've also assumed an equal cost for unit #4 as my current rent, as I am going to move into this - if I rented it out externally, I would predict $1200 -$1250 in rent based on comps.

Expenses

I'm assuming all other expenses are in the mortgage. I'd like to save approximately 10% to cover unforeseen repairs, etc. Given the new floors, new electric, new kitchens, new bathrooms, new windows, new HVAC, new roof, etc, I do not anticipate too much for this, but prefer to be safe than sorry.

The Financials

So... upon first glance, things look "ok". I'm cash flow positive (assuming I account for me own cost of living, or rent all 4 units). I've got a cap rate of 9.23%, which is not too bad, and a cash-on-cash of 23%. As a complete newbie to this (I've been reading BiggerPockets for about 1 week), this sounds like a green light for the project. Could I be missing something? ...what scares me the most is that I created this spreadsheet based on reading a post on BP linked to the beginner's guide. I am not 100% sure that this is correctly calculating everything. Also, the numbers change dramatically if my assumptions change about the project. What if I get higher vacancy rates? ...what about having to reduce rent? What if my common space utilities end up costing more than $100? ...are there costs I am not calculating? ...and so many more questions!?!?!

According to the Rules

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Cory BinsfieldPro Member
Financial Advisor · Duluth, MN · Member since 2012 · 157 posts · 194 votes
12y

Alex, do the tenants pay utilities? $100/mo seems extremely low. I'm thinking water, heat, sewer, garbage, lawn care and or snow service, etc.

Also, I'm assuming the taxes and insurance are zero since you rolled that into the loan.

At first glance the numbers seem ok. However, if your dropping $400,000 on a property with only 3.5% and it's cash flow positive I feel it's a good deal.

My biggest concern is the after repair value. What are similar fourplexes selling for that include a garage? Unlike multi family income property (5 units or higher), 4 unit properties are based upon comparable sales and not cash flow (NOI and Cap Rate).

Lastly, is their a higher and better use for a FHA loan? As a newbie investor, your not only buying in a distressed area, you are also taking on a major construction project.

Is it possible to spend $300,000 to $400,000 on a turn key property that's in a great rental area without the hassle of living in a construction zone? As you work on the units and bring in tenants, some of the tenants will become annoyed over the construction activity.

Just some thoughts. I like the deal but it looks like a major time suck for a new investor. It seems like a sweet deal for a well capitalized and seasoned investor. If my thoughts get you more worried, perhaps you could sell the deal to someone else at a profit and take the proceeds and use it to build up your reserves.

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  • JT Spangler
    Buy and Hold Investor · Nashville, TN · Member since 2013 · 264 posts · 102 votes
    12y

    Looks promising thus far. Where'd you get your rehab numbers from, and do you have a contractor lined up to do the work? 203k comes with extra hoops, and not everyone wants to mess with them.

    0Reply
  • Alex M.
    OP
    Investor · Philadelphia, PA · Member since 2013 · 185 posts · 97 votes
    12y

    Hi JT,

    Thanks for the quick response on my post. The rehab numbers come from three separate locations:

    1. My FHA/HUD consultant conducted the required FHA/HUD inspection and provided me with an estimated cost for loan purposes.

    2. I created a spreadsheet and used conservative estimates of cost by sq.ft. and other units to evaluate cost for entire project.

    3. A contractor evaluated the property with me, and walked around talking about the proposed improvements.

    I have not yet committed to any contractor for this. I will need to get an architect to draw up plans, submit this to FHA Consultant, and the put this out to bid to the contractors. At this point I will have more definitive numbers, but am only going to pay the architect if my first glance cost assessments make sense.

    0Reply
  • Alex M.
    OP
    Investor · Philadelphia, PA · Member since 2013 · 185 posts · 97 votes
    12y

    The other thing to add here (it looks like it got cut off my first post), is what does the property look like when using BP rules of thumb:

    Using these rules, the numbers don't look anywhere near as good as the other assessment. This worries me. Can any experienced investors provide guidance here? I'd like to know why these are so poor, when cap rate and cash-on-cash look okay.

    Also... none of these analyses are considering the additional rent estimate of $1300-$1400 for the loft-style unit that I can build into the large brick garage. Not sure if I should consider that in my analysis, or if that is too "speculative".

    0Reply
  • Cory BinsfieldPro Member
    Financial Advisor · Duluth, MN · Member since 2012 · 157 posts · 194 votes
    12y

    Alex, do the tenants pay utilities? $100/mo seems extremely low. I'm thinking water, heat, sewer, garbage, lawn care and or snow service, etc.

    Also, I'm assuming the taxes and insurance are zero since you rolled that into the loan.

    At first glance the numbers seem ok. However, if your dropping $400,000 on a property with only 3.5% and it's cash flow positive I feel it's a good deal.

    My biggest concern is the after repair value. What are similar fourplexes selling for that include a garage? Unlike multi family income property (5 units or higher), 4 unit properties are based upon comparable sales and not cash flow (NOI and Cap Rate).

    Lastly, is their a higher and better use for a FHA loan? As a newbie investor, your not only buying in a distressed area, you are also taking on a major construction project.

    Is it possible to spend $300,000 to $400,000 on a turn key property that's in a great rental area without the hassle of living in a construction zone? As you work on the units and bring in tenants, some of the tenants will become annoyed over the construction activity.

    Just some thoughts. I like the deal but it looks like a major time suck for a new investor. It seems like a sweet deal for a well capitalized and seasoned investor. If my thoughts get you more worried, perhaps you could sell the deal to someone else at a profit and take the proceeds and use it to build up your reserves.

    Podcast Guest on Show #86
    2Reply
  • Alex M.
    OP
    Investor · Philadelphia, PA · Member since 2013 · 185 posts · 97 votes
    12y
    Originally posted by @Cory Binsfield:
    Alex, do the tenants pay utilities? $100/mo seems extremely low. I'm thinking water, heat, sewer, garbage, lawn care and or snow service, etc.

    Also, I'm assuming the taxes and insurance are zero since you rolled that into the loan.

    Thanks for the comments. Very helpful. The tenants are paying utilities (part of my rehab is to add new meters, wiring, plumbing and HVAC systems, so each unit is fully separate). The taxes and insurance are included in the mortgage cost. What kills me here is the PMI - $406 per month....!?!?! However, it does look like the numbers do work on it.

    I really appreciate your comments on experience and the recommendation to potentially sell the deal. The flip side to this, though, is the intense crash course learning opportunity for doing this as a newbie. If I can get through it, the next property is not going to be as daunting - my investment plan included focusing on transitional neighborhoods and distressed properties. Mostly MF, but some SFH also.

    0Reply
  • Jeff Greenberg
    Real Estate Consultant · Camarillo, CA · Member since 2010 · 2k+ posts · 1k+ votes
    12y

    @Alex M. Where is the 5k in expense coming from. The 50% rule put your expenses @ 20,500.

    "I'm assuming all other expenses are in the mortgage." Why are you assuming that. You may have to escrow the taxes and insurance, but add that on top of the mort. How can the future taxes and insurance be rolled into the loan. You need to find out what those prepaid items are. Maybe first year T&I, but what about the following years.

    I don't see management(are you self managing), no marketing, no general admin(FHA loans are killers with the paperwork, CPA), contract services(pest control, lawn, Trash).

    We are missing some of the picture here

    0Reply
  • Account Closed
    Involved In Real Estate · New York City, NY · Member since 2013 · 25 posts · 2 votes
    12y

    Alex, I find this very interesting as I too am a new investor and am hoping to purchase a multi-family with an FHA 203K sometime in the future. Since I'm a newbie, would you be so so kind as to explain each of these charges in a little more detail to me so I can understand them properly? You can e-mail me directly at: [REMOVED] as I know this is a little off topic !

    1) Mortgage Payments Escrowed? What exactly does this mean?

    2) FHA Inspection fees? Is this the same no matter what you are purchasing? It is a one time charge for once refurb is completed? And is it rolled into your mortgage payments or an extra upfront cost?

    3) FHA consultant fees? Is this always necessary with this type of loan and is it rolled into your mortgage payments or an extra upfront cost?

    4) Is the origination fee built into your mortgage payments or is at an extra upfront cost?

    5) Permits? Is this cost required by the city to allow the refurb to take place?

    Thank you kindly and best of luck to you !!!

    0Reply
  • Alex M.
    OP
    Investor · Philadelphia, PA · Member since 2013 · 185 posts · 97 votes
    12y
    Originally posted by @Jeff Greenberg:
    @Alex M. Where is the 5k in expense coming from. The 50% rule put your expenses @ 20,500.

    "I'm assuming all other expenses are in the mortgage." Why are you assuming that. You may have to escrow the taxes and insurance, but add that on top of the mort. How can the future taxes and insurance be rolled into the loan. You need to find out what those prepaid items are. Maybe first year T&I, but what about the following years.

    I don't see management(are you self managing), no marketing, no general admin(FHA loans are killers with the paperwork, CPA), contract services(pest control, lawn, Trash).

    We are missing some of the picture here

    Hi Jeff,

    Great questions. You are helping me to look at this even deeper, and I appreciate it. The 50% rule puts me at $20,500, as you said. My expenses in my spreadsheet have me at $5,352. However, Taxes and Insurance being included in my mortgage payment are as follows:

    If I add these up, for a year, I get $9,021.84. If I then look at my projected vacancy rate of 10%, I have an additional $2,880 per year.

    $5352 + $9,021.84 + $2,880 = $17,253.84. Slightly under the $20,500, but pretty close. For the sake of being conservative, if I add the difference in to the calculations and rerun my cap rate and cash-on-cash, I am now at an 8.4 cap rate and a 17% cash-on-cash. Not quite as good, but still looking positive.

    Also - I am managing this myself, as I will be living in the property for the first year or two at least. Once I move out, if I am fortunate enough to have succeeded on this path, I will then move this over to a property management firm.

    0Reply
  • Alex M.
    OP
    Investor · Philadelphia, PA · Member since 2013 · 185 posts · 97 votes
    12y
    Originally posted by @Account Closed:
    Alex, I find this very interesting as I too am a new investor and am hoping to purchase a multi-family with an FHA 203K sometime in the future. Since I'm a newbie, would you be so so kind as to explain each of these charges in a little more detail to me so I can understand them properly? You can e-mail me directly at: [email protected] as I know this is a little off topic !

    1) Mortgage Payments Escrowed? What exactly does this mean?

    2) FHA Inspection fees? Is this the same no matter what you are purchasing? It is a one time charge for once refurb is completed? And is it rolled into your mortgage payments or an extra upfront cost?

    3) FHA consultant fees? Is this always necessary with this type of loan and is it rolled into your mortgage payments or an extra upfront cost?

    4) Is the origination fee built into your mortgage payments or is at an extra upfront cost?

    5) Permits? Is this cost required by the city to allow the refurb to take place?

    Thank you kindly and best of luck to you !!!

    Hi Darren,

    Really glad that you are finding this useful. Taking the plunge here is very nerve wracking, but exciting at the same time. FHA 203k seems like a complex offering, but it also appears to be a really excellent way of finding the funds to do a rehab. Your questions are relevant to the process, so I'm going to attempt to answer them here. First, let me start by stating that there are two different types of FHA 203k that you will encounter: the standard and the streamlined. The streamlined only allows up to $35k in improvements, does not require a consultant, and is not relevant to my analysis or your questions. For improvements costing more than $35k, the standard is the FHA 203k that you will encounter.

    1) Mortgage Payments Escrowed - The FHA 203k allows you to escrow up to 6 months of mortgage payments and include that as part of the rehab loan. This covers the mortgage costs while construction is happening. Obviously, the quicker construction happens, the sooner you can put paying tenants into the property, and the better your financial position. I'm hoping to drive construction hard and use as few of these payments as necessary. What is left unused will be rolled back into the loan to buy down the principal.

    2 and 3) FHA Inspection + Consultant Fees - the FHA process IS complex. A consultant comes out and charges you a one-time up-front cost to inspect the house and do a "feasibility analysis". This provides you with an initial report and a ballpark cost to do improvements. From there, the process can vary a little. For me, I need to get an architect on site (which I am not yet clear if I pay out of pocket or can roll into the loan - my analysis assumes it is part of the loan). Once the architect has drawn up plans, this then goes back the consultant, who completes their assessment, draws up a plan, and supports the bid process for contractors. Once I receive those bids, they go back to the FHA consultant, I let them know who I am selecting for the work, and the bid price goes back to the lender who finalizes the finance package and begins to underwrite the loan. Once I get to closing, all pieces are lined up to do the following: 1) I get the keys. 2) the contractor begins work, 3) the FHA inspector evaluates the project on a monthly basis (inspections) and determines the payment eligibility for the lender to pay the contractor 4) this happens again and again and again, until the project is completed. For my project, I am working with a very experienced FHA consultant and paying slightly higher than average fees to gain the benefit of her knowledge as this is a large project and I want to minimize risks. You can find HUD recommended cost guidelines on the HUD 203k program website.

    4) Origination fees, as I am learning, are part of the fees that a lender receives for doing business with you. The lender charges these and gets paid for them at closing, but the cost is rolled into your mortgage.

    5) Permit costs are a ballpark by my lender. I have NO clue what they actually are going to be. These are the costs for all necessary permits to move forward with my proposed and required improvements. I am assuming this cost will change a little, but not sure if up or down.

    I hope this answers your questions. I encourage you to do your own research on top of this, as I am probably the furthest thing possible from an expert on any of this, and there may be many inaccuracies with what I have stated above. Best of luck to you also. I look forward to hearing from you when you get started with your project.

    0Reply
  • Steve Babiak
    Real Estate Investor · Audubon, PA · Member since 2009 · 13k+ posts · 8k+ votes
    12y

    What the heck is "water fees" on the income side of things? Not a good idea in PA - see this thread:

    http://www.biggerpockets.com/forums/52/topics/107306-triplex-without-separate-utilities?page=1#p685629

    The rents you posted are high enough that the 2% rule won't apply. But I still like to see things be over 1% - being below 1% is almost going to guarantee negative cash flow.

    Then we have to look at the 50% rule number you gave. Since the 50% rule estimates that expenses will be 50% of rent, that means that the principal and interest parts of the mortgage cannot exceed 50% of rents in order to be break-even. Your mortgage number is way bigger ... Maybe you'll be able to operate with lower expenses, but 35% to 40% is about as low as anybody could advise for analysis - and those lower percentages mean that it is a riskier thing for you being new to this.

    0Reply
  • Steve Babiak
    Real Estate Investor · Audubon, PA · Member since 2009 · 13k+ posts · 8k+ votes
    12y

    BTW - if this is inside the Phila city limits, what's the zoning? If zoning is commercial, FHA might not work; be sure to inquire about that if it is commercially zoned.

    0Reply
  • Alex M.
    OP
    Investor · Philadelphia, PA · Member since 2013 · 185 posts · 97 votes
    12y
    Originally posted by @Steve Babiak:
    What the heck is "water fees" on the income side of things? Not a good idea in PA - see this thread:

    http://www.biggerpockets.com/forums/52/topics/107306-triplex-without-separate-utilities?page=1#p685629

    The rents you posted are high enough that the 2% rule won't apply. But I still like to see things be over 1% - being below 1% is almost going to guarantee negative cash flow.

    Then we have to look at the 50% rule number you gave. Since the 50% rule estimates that expenses will be 50% of rent, that means that the principal and interest parts of the mortgage cannot exceed 50% of rents in order to be break-even. Your mortgage number is way bigger ... Maybe you'll be able to operate with lower expenses, but 35% to 40% is about as low as anybody could advise for analysis - and those lower percentages mean that it is a riskier thing for you being new to this.

    Steve - As with all the other comments, I really appreciate your time and input, and that you are forcing me to evaluate the calcs I am making. I have reviewed my numbers and here's what I think directly responds to your questions. Please do let me know if this still looks okay, or if I am missing something:

    1. Water fees - these are a small fee that I will apply to each apartment, in addition to the base rent. This fee is equally split, and should cover the cost of water/sewer for the building. I am not sure yet what these costs will be, don't want to individually meter, and would like to minimize expenses for myself. In the apartment that I currently live in, the landlord applies this fee to everyone, and it seems to work.

    2. Thanks for the comments on the 2%... I'm concerned about the less than 1% meaning likely negative cash flow. Not sure what to do here. Cash flow does look to be positive, but this number is not great.

    3. the 50% rule that I showed included P&I and insurance and taxes and all in the mortgage cost. When I reduce it down to just P&I ($1953 a month), the calc looks more like this: $3460/1953 = 56.4%, or stated differently, I have around 44% of my rent remaining to pay expenses after the mortgage payment (P&I) is taken care of. Is this a reasonable number, or should I be worried?

    0Reply
  • Alex M.
    OP
    Investor · Philadelphia, PA · Member since 2013 · 185 posts · 97 votes
    12y

    Also,

    @Steve Babiak I did include vacancy assumptions in my rental income for the 2% rule. If I take those out, and just look at income, then the calc is 0.94% when assuming all cost overruns and 6 months of construction. If I drive down those cost overruns and construction time, the rate goes to 1.004%... not much over 1%, but squeaking over. Do these numbers look any better?

    Finally - the zoning is residential. RSA-5. With pre-approved zoning for MF up to 5 units.

    0Reply
  • JT Spangler
    Buy and Hold Investor · Nashville, TN · Member since 2013 · 264 posts · 102 votes
    12y

    I think the thing that pushes me over the top is your potential for appreciation and being able to add a 5th unit. If you do, my understanding is you'd be able to refi with a commercial lender, who will value the property entirely differently than a residential property (4 units or less). Which means if you manage well and collect maximum rent for the area (which, after your reno you should be able to), they'll potentially give you some equity in that valuation, which might make it so you can refi without PMI.

    So if your expenses are good, rents are good, cap rate and cash on cash is good, I like it. This is a good example for understanding why the guidelines work the way they do. Your COC is awesome, for instance, because you're getting a huge loan with little down (300k for 15k ish?), but your expenses are high in part because your debt servicing numbers are huge (due to 400/mo PMI, of course, this is precisely because you're getting so much loaned with so little in). If you are confident the area will continue to grow strongly, I think it's a good buy. If it were me, I'd dump every dollar of cash flow into either extra principal payments or a construction fund to build out the 5th unit. The sooner you can ditch PMI the sooner this becomes a nice cashflow property and you don't have to count as heavily on appreciation.

    I'd shoot for finding a way to finish that 5th unit in ~2 years or so, and at that point you can stop owner-occupying and be collecting rent on not only your unit, but also the 5th. That brings your monthly GOI up to nearly 5k. Of course, you'll have to figure out some way to pay for that construction, but if you're really attentive to the reno process the first time through, you can probably be the GC for that smaller reno and do it on a tighter budget. But you should be able to get a 1% property by then, and at that point you may be ready to turn it over to a PM.

    Then, it'll be on to the next deal for you.

    1Reply
  • JT Spangler
    Buy and Hold Investor · Nashville, TN · Member since 2013 · 264 posts · 102 votes
    12y

    Two other things to consider: if it were me, I'd be occupying the smallest unit instead of the largest. This puts an extra 400-500 bucks of real money into your bank account. Since you're going to be leveraged up to your eyeballs and running on really thin margins, this is a no brainer to me.

    Additionally, until I came up with the funds to build out the loft apartment, I'd rent it as garage/storage space to the tenants. You could offer them access for $50/month, or whatever is fair, and potentially add another $150/month to your cash flow.

    1Reply
  • Lorenzo Martinez
    Rental Property Investor · San Antonio, TX · Member since 2020 · 24 posts · 6 votes
    6y

    Just wondering how this evolution turned out?

    0Reply
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