Real Estate Deal Analysis & Advice
Market News & Data
General Info
Real Estate Strategies
Landlording & Rental Properties
Real Estate Professionals
Financial, Tax, & Legal
Real Estate Classifieds
Reviews & Feedback
Updated almost 11 years ago, 01/28/2014
9% cash flow pot house, want your opinion
I have a deal which I structured owner financing in it, my plan is hold on to it and will either sell it at the end of the loan period or just keep it.
It is a SFR, ARV is ~ $450k, I am buying it at $461k. The deal is actually in the financing. The way to pay it off as follows:
$30k down today.
first 5 years, monthly payment $1100
2nd 5 years, monthly payment $1175
3rd 5 years, monthly payment $1250
At the end of the 15th year, there is a balloon payment for the remaining balance of ~$220k.
The current market rent is about $2200, so excluding the property tax, insurance, cash flow is about $600/ month.
Fix up cost is ~ $50k
So the cash on cash return just on the cash flow is 9%/yr. (the rent tends to go up by 3% yearly in my area, so by the 6th year, rent will go up to $2550/ month and by the 10th year, rent will go up to $2956/month)
And assume I sell it at the same price 15 years from now at $461k and pay off the $220k, I still net ($241k - closing cost / fee) at the end of the 15th year.
However, there is some settling issue in the concrete slab foundation, which I don't plan to fix, I'll just fix the door frame and window frame to make it rentable.
There is another issue, it seems the current tenant is grow pot (they insisted it is for medical use and said they have the license to do so) in the converted garage, which they don't allow me to get in. They are planning to move out though.
1st question is should I close after the tenants move out or just buy it as is and kick them out myself, I don't know what the landlord's liability is if tenants are growing pot in the house.
2nd question is what is the negatives you see in the deal, other than a long holding period and negative equity at the beginning (It will take roughly 11 years to get my down payment and fix up cost back)
3rd question, what is the best exit strategy?
Thanks @Account Closed , finally got someone who knows how the local market works.
You are right, it is a property in class C of the market. It is in Milpitas.
Prices in class A and B in the Bay Area has already gone past the peak in 2007, I do expect that would follow by class C, D, E....neighborhood in the Bay Area.
After everyone's feedback, I don't think I would hold on to it for 15 years. Last time during the peak in 2007, it was around $650k in that neighborhood. There is one similar house just went pending last week at $625K after 8 days on the market, I am just being very conservative with my numbers. $450k is the price for short sale.
I am expecting this one would hit $570k within the next 7 years and I will just sell it.
Originally posted by @Yu L.:
You are right, it is a property in class C of the market. It is in Milpitas.
Prices in class A and B in the Bay Area has already gone past the peak in 2007, I do expect that would follow by class C, D, E....neighborhood in the Bay Area.
After everyone's feedback, I don't think I would hold on to it for 15 years. Last time during the peak in 2007, it was around $650k in that neighborhood. There is one similar house just went pending last week at $625K after 8 days on the market, I am just being very conservative with my numbers. $450k is the price for short sale.
I am expecting this one would hit $570k within the next 7 years and I will just sell it.
Using 0% financing for a buy and hold is very hard to screw up. For one where you know you are going to hold it for some period of time and then sell it, I'd recommend structuring the note differently.
Yu,
Although I anticipate the rate of appreciation will moderate this year and the next couple of years, I believe there is a high chance that you will get your $570k price in the next 3 to 5 years instead of 7 years. We are still in the early stage of our Tech 2.0 IPO phase. Therefore, I expect more tech money as well as money from oversea to be pouring into real estate for the next 2 to 3 years. My friend just lost out on a tiny tear down shack on a 13,500 sq.ft. lot in Los Altos to another all cash offer of $1.93M. His offer was only $1.88M. The house was listed for $1.6M. This is only one of many stories from my friends as well as my "A' class tenants, who are trying to buy a house and kept getting outbid. Of course, this is only one man's opinion. Don't place any bet on an unknown individual from the internet. :)
Since you mentioned it is a short sale, there must be more to the story. Otherwise, the numbers in your initial post don't make sense. Perhaps, it is an equity sale where the owner defaulted on the loan? Anyways, good luck.
Originally posted by @Duncan Taylor:
Using 0% financing for a buy and hold is very hard to screw up. For one where you know you are going to hold it for some period of time and then sell it, I'd recommend structuring the note differently.
Great point. Maybe it's time for Yu to have a talk with a real estate attorney to keep himself out of potentially hot water with the IRS as well as the owner or his siblings suing Yu's behind some years down the road.
@Account Closed , no it is not a short sale, what I meant is $450k is the price for a short sale in that neighborhood.
@Duncan Taylor what is your recommendation on the note if I plan to sell before maturity.
@Yu L. As mentioned above, be sure to factor in an "operating Reserve" to handle Vacancy, Repairs and Maintenance during the life of the hold. We use 15% of rent at MINIMUM (in nicer properties), and up to 25% in lesser, older properties. So, you would set aside $330 per month into a reserve account. It may or may not be enough to handle repairs, etc. but you should at least assume it isn't part of your ROI. So, that makes your monthly cash flow $270 at best. Annual $3240. So if you have $80000 into it your ROI is 4.05%.
We structure similar deals here in KC, and yes, you should use the Applicable Federal Interest rate (changes monthly - and varies by term length - check this at www.bankrate.com) I just wrote a 9-year seller financing deal at 1.95% (over 9 years is 3.32% I believe). We do explain to the sellers that getting a higher sales price and less interest MAY be to their tax advantage (but please consult your tax advisor - I am not one). If they want a higher interest rate we lower the price so that the total payout is the same.
Yu,
I guess you meant $450k WAS the price of a short sale in that neighborhood. :)
This is speculative, but so is any kind of investment. I can almost see Milpitas and North San Jose will get more expensive in the near future. Home prices in Fremont Mission San Jose School District are outrageously expensive so people migrated south. A lot of Chinese and Indians are moving into these two neighborhoods. This might have resulted in the improvement of API scores in Milpitas and North San Jose schools in the recent years. These areas already have several schools in the 900's API range, and it's only getting better as more Asians moving in. If the subject property is in Sinnott or Curtner School District, you just got yourself a sweet deal. Certain parts of Curtner School District is in flood zone so be careful there. Other than that, good luck with your bet.
I'd rather cut my hand off than do this deal.
Betting on appreciation may make you some money, but in the long run your *** will get burned.
@Mike Bryant so you structured the deal based on the IRS AFR rate? The rate is changing monthly, do you need to adjust the rate every month then?
Originally posted by @Yu L.:
Let me be blunt, if you can't get the rents up, you shouldn't do this deal at all in my opinion.
I wouldn't.
I would be doing you a disservice to make any recommendations on the note.
@Yu L. To answer your question, the Note is written at the current AFR and that stands for the whole term. Its not an "adjustable rate". I will produce an amort schedule with the fixed 1.95% interest rate.
In reviewing other comments as well, I agree that the $2200 rent is quite low for a $450k property. Of course I don't know your market, but the numbers don't work unless you are buying it cheap and as you said, look to do the repairs and then flip it for your profits.To hold it does not seem to make the most sense. How are you funding the $80,000? I just can't make the numbers work on this deal....
In contrast, we just had an offer accepted on a small 10-unit building with NOI of $28,200 (using the 50% rule), and we are paying $185,000 for it, with $15,000 down and the seller carrying a Note for $173,500 at 1.95%. Needs $60,000 in rehab. The ARV is estimated to be $250K, but using the income method, it might be closer to $300k. The payment on this Note is $1150 per month with a balloon after 9 years of $56,000. It does need approx $60,000 in rehab, so we will bring in $90,000 in Private investor funds at purchase, ARV is $250K. Essentially we paid the seller full market value (less repairs) in exchange for great terms over 9 years. Our payment to the seller is right at 50% of the NET monthly cash flow (after the 50% rule).
GROSS RENTS = $4700, Less 50% rule = $2,350 NOI (Monthly)
Private Lender 1st = $750 interest only - could roll to a P & I refinance down the road.
Seller carry 2nd = $1150 (@1.95% interest) rapid principal paydown.
Net Monthly Cash flow = $450 - or $5400 annually after all debt service and expenses.
Maybe my numbers will vary a bit from this once we get into it, but our projections are fairly conservative, and we plan to renovate and hold this property for at least 9 years, then worst case scenario we will owe the $90k first and $56k 2nd, and if there's no appreciation the building would still be worth at least $250k. Any appreciation is gravy. Also we hope to complete the rehab on $50,000 and built in an extra $10k as a buffer. We have learned to run our numbers always based on worst-case scenarios. Been there, done that on the "pie in the sky" projections.
Man, with 500K, just buy 8 SFR's here in warren and get 1100 in rent per. You'll be at 8800 in rents.
I'll take the 4x monthly rent over the pie in the sky deal that maybe this area will boom someday.
I must chime in again.
1- as I initially thought, it is an appreciation play, being in a reasonable area (i.e. not in a gang/war zone.)
2- you're getting in at a discounted price.
3- I agree with Minh, short to mid term appreciation is very likely. Same thing happening in my market, San Francisco. All the mid-high end is going through the roof. Folks with lesser means are reinventing C class neighborhoods as we speak. The caveat though is when a downturn occurs, the lesser areas can drop much more than the better ones (just compare price drops in Militias to Palo Alto, during last downturn :)
4- you should have no problem covering any maintenance/vacancy issues with your excess cash flow. Just be smart about it. If it were me and I was planning to hold for 3-7 years, I'd sh¡t-can the pot growers ASAP. Fix and do cosmetics to the basics so it shows well, and get decent tenants in there. The out of state commenters here who rent cheap units at $600-800/month and earn $100 per door have totally different cost structures. i.e. A bad water heater or fridge wipes out their profits for 6 months. You would only lose one month of cashflow.
5- as for when to sell this, that is difficult to answer. If area continues improving, you may want to hold this long term, especially as it cashflows more and if it's easy for you to manange. That's how the big bucks are made.
This is a promising deal IMO, giving you the chance to get a decent property in the Bay Area. But the devil is in the details! Only you can make all the necessary observations to ferret those out. Good luck!
How do we know that prices will continue to appreciate? We already went through a major crash. I know several people who are having to pay several hundred dollars more each month due to Obamacare. Once that kicks in full speed, I think we could see home values take another hit as household budgets feel the pinch.
I'm not an appreciation buyer. I look for cashflow and consider appreciation to be a bonus. I would still run from this horrible "deal".
@Mike Bryant the rate you mentioned 1.95% is still below the AFR, so the imputed interest rules would still kicks in. How do you handle that?
http://www.irs.gov/pub/irs-drop/rr-14-01.pdf
It's actually 1.75% for the mid-term AFR according to the document from the IRS. My software loaded 1.95%. I'm overpaying!! What did you look at to think it was higher than 1.95%
Short term AFR = 1-3 years
Mid-Term AFR = over 3 to 9 years
Long Term AFR = Over 9 years.