9% cash flow pot house, want your opinion

[Yu L.]

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?

[Wayne Brooks]

If they're growing pot, I'd expect better than a 9% return.

Edit: When I posted there was no body to the post, only the title.

[Brian Gibbons]

Wayne Brooks that's my fav post of the day!! Everybody press the vote button!!!

[Yu L.]

The 9% is after the current tenant move out, if I keep them there, the cash flow is -ve.

[Wayne Brooks]

You're ignoring a lot of ongoing costs....vacancies, repairs, maintenance, capital expenditures, etc. also, it seems this is structured as a no interest loan. That will cause issues for the seller, as the IRS will impute/tax the seller at a minimum interest income rate, right now I think about 4% or so.

[Yu L.]

@Wayne Brooks can you elaborate on the IRS tax issue?

I assume the $50k fix up will fix all major issues for the next 10 years.

[Sean Kuhn]

It seems to me like there's easier ways to make 9%. As far as the tax thing goes, the IRS insists any loans between people have a minimum interest rate.

[Bill Gulley]

The best exit would probably be out the back door if you see them coming for you. With my luck the neighbor would sell to a DEA agent with a dog, the dog would go nuts and the place would be raided! My tenants would be arrested from all the trash left behind, I'd get sued and involved as the place would be mine, the house confiscated and sold at auction to ......yes, the highest bidder!

I sense a bit of pride in figuring out the creative side of this, how close to the garage did you get and was there any noticeable odor, anything burning, before you thought this would be a good deal?

If rents go up 3% a year I'd bet maintenance and other expenses go up as well, I doubt you can get 3% net increases every year without the amenities grown being included, maintained, harvested and probably distributed.

Another no interest deal? The seller will get high off the imputed rate on that amount, be sure to disclose that, last guy to tick off would be some grower type.

Right, I'd just go over and start tossing their stuff out, did you verify this license or did they print one up for the owner, if it is the real deal, how do you know they are in compliance and not growing more for friends, like the ones who may come visit you after you start kicking them out all by yourself.....

This one takes the cake! :) LOL

[Rob K.]

Why would you even consider purchasing a house for $461K that has an ARV of $450K and needs $50K in repairs?

[Brian L.]

I think, the pot growing issue aside, the deal doesn't look like a winner to me. Of course I'm in Colorado so its easy for me to brush aside the pot issue ;-)

[Bill Gulley]

Originally posted by @Yu L.:

@Wayne Brooks can you elaborate on the IRS tax issue?

I assume the $50k fix up will fix all major issues for the next 10 years.

Yu, kidding aside, you need to study a bit more before getting creative. Just one issue is "imputed tax" rates on financing, the rate changes every year and will be a real tax mess for that seller, it could backfire on you.

Your long term assumptions need more consideration.

Is there a loan, I forgot due to the odor (okay, no more pot shots) long term, the due on sale, it can pop up and you won't be able to refi that deal without more money thrown in. You put 50K in the MV may not budge much. What's the ARV?

This isn't a deal. :)

[Steven Hamilton II]

Actually imputed interest is based upon when it originates. It also is not an issue for the buyer. Leave it up to the seller. It is not your job to tell them, nor is it your job to explain it to them.

[Bill Gulley]

Steve is right, the rate applies at origination, I had a brain phart.

I'm sure Steve was speaking as to the tax disclosure, HOWEVER, absolutely not so that it's all on a seller, not by any long shot folks, especially from the bunch that calls themselves investors doing deals as a business approaching seller having less knowledge and not having a clue when they say this guy told me. That is what attorneys do. Don't ever think you can go out and mess over Johnny homeowner and walk off with immunity saying it's on him. That's not the right frame of mind to be in. True, it's not your job to give tax advice, but you better disclose any issues you put or could be putting someone in, at the very least make them sign something that advises them to seek legal and tax advice.

You need to start drilling down a little deeper into what can and has happened when someone does some predatory, uncommon, unusual, convoluted transaction that they got someone involved in. :)

[Jerry W.]

@Yu L. let me tell you my concerns. First I am not worried about the pot, I am sure they would never leave it or risk a deputy coming in to evict them, I would be more worried if it smelled like cat urine, ( one sign of a meth lab)

The math on this one is really flawed so it is hard to evaluate.

First by paying for the house over market price but not being charged interest you are losing the deduction you get from paying interest, that is only partially offset by getting more depreciation.

Second you can never prepay this thing as your interest is already in your cost to buy. If you try to refinance early you lose money like crazy. this means you lose a very important exit strategy of being able to sell if things go bad like no renter, prices start dropping, or you need to move to another part of the country, etc.

Third you are losing money when looking at this from a cash flow. Hopefully you have heard of the 50% rule. That basically says that half of your rent income goes to expenses. You think that everything not spent on taxes and insurance is profit. HUGE mistake. What if the heater or air conditioning goes out? Where is the money to repair it? I spent $4,000 recently for a problem with a sewer line that ended up being a chunk of plastic lid off the sewer cleanout. that is not in your calculation. What about vacancies? Evictions? Cost of advertizing? Replacing the roof when it wears out? Get the idea?

When you factor in the cost of fix up you really lose money. Your mortgage payment is not part of expenses and it goes up every 5 years so you lose more unless rent goes up faster, a dangerous gamble for those with no crystal ball. Do you have the money from your day job to make these payments if it is not rented?

There are very good things about this deal. First you are buying it for monthly payments that are less than what you would pay monthly for interest. Even using your ARV of $450K the payments at 5% interest at 30 years would be over $2,400 per month, your payments are less than half of that. Interest alone with no principal would be $1,875 per month. Yet you are buying it for 40% less than that.

All of that being this deal does not cash flow. If you have the money to makeup your negative cash flow of your higher payments in later years and pay the $50K out of pocket now and not borrow it at the end of 5 years the property will be worth exactly what is owed assuming no change in value.

At the end of 12 years you finally get where you need to be. Assuming no change in value you will owe 80% of what it is worth. That is where you want to be. You have enough equity to refinance with a bank. you will have to pay $75 per month out of pocket for 5 years and $150 per month for another 5 years to get to where you sell it. I have not factored in that expense.

If you manage the property yourself it should easily offset the monthly cost increase the last 10 years but it will be a part time job you could have done for cash in your pocket.

This deal is a high dollar deal that will eventually be a decent payout at 15 years but you have to be ready work on it with no real profit for 15 years. You must have the $50K to repair it now and be able to part with it with no bank loan. It is nice to turn large profits on deals so you only need do 3 or 4 to make huge money. the drawback is they are very expensive and very risky. If the market tanks again you cannot refi to get out.

I am very lukewarm on this deal. Good luck either way.

[James Wise]

Who pays the electric bill? Those grow lights get get expensive.

[Andy Collins]

Your assuming the $50k fix up will take care of all repairs for 10 years on a $450k house,,,it just doesn't work that way.

andy

[Ben Reese]

While there is "hair" on this deal, those of you critiquing the so called purchase price are missing the essence of this sort of opportunity. Assuming I've done the math correctly, the sum of all the payments (including the down payment and 50K of renovations) over the next 15 years is about 510,000, Assuming a 6% interest rate the Present Value of these expenditures, is about $305,000. So if we are to assume the PV (or purchase price) is $461K the implied interest rate is about 1%. That's cheap 15 year financing. There is money to be made here if other problems can be corrected.

Now correcting problems is the essence of most real estate opportunities. If I were looking at this I'd want to ensure there was no illegal activity in the home at the time I purchased it and so would insist the tenants vacate before I held title. I would not want to knowingly buy a home where the rennet's were engaging in illegal activity. Too many risks in that and for little cost you can find new and less risky tenants. I'd also have an engineer look at the foundation before I took a chance on it.

Ben

[Rob K.]

Originally posted by @Ben Reese:

While there is "hair" on this deal, those of you critiquing the so called purchase price are missing the essence of this sort of opportunity. Assuming I've done the math correctly, the sum of all the payments (including the down payment and 50K of renovations) over the next 15 years is about 510,000, Assuming a 6% interest rate the Present Value of these expenditures, is about $305,000. So if we are to assume the PV (or purchase price) is $461K the implied interest rate is about 1%. That's cheap 15 year financing. There is money to be made here if other problems can be corrected.

1. 15 years is a LONG time. Things change and if a profit is ever made on this horrible deal, that's a long time to wait for it.

2. As soon as he closes on the house, his net worth drops $61,000. I always look for cash flow and an increase in net worth when I buy something.

3. I wouldn't consider buying anything that only paid a 9% return. Those numbers are ugly.

I would run from this deal even if drugs weren't being grown there. The fact that it's a drug house only makes it worse.

[Yu L.]

sorry, there was a typo. It should be "after" property tax and insurance.

Here comes the numbers:

rent: $2200

mortgage payment: $1100

property tax: $400

insurance: $100

cash flow: $600

The way I look at it is 9% cash flow for the holding period with a big pay day down the road.

ROI on the big pay day is over 250%

[Sean Kuhn]

Vacancies and repairs will be 20% as well. That's 440 off the top. So your real cash flow is 160 a month. If I were you I'd buy 3 or 4 SFR and cash flow 600-800 total on all four.

[Sean Kuhn]

Also Yu, and I'm trying to be nice, 15 years is a long time to wait for one pay day. There's going to be a high opportunity cost here too, I bet you could make more in that 15 years in another way.

[Dawn Anastasi]

If all you have is $30k, why not get 9.5% out of that money over 5 years and then you'll actually be earning money instead of losing it? I would have to agree with others; we're not trying to tear down your idea, you have the creative part right, but the actual numbers aren't making sense.

[Duncan Taylor]

The problem with the deal isn't the 0% financing.The problem is the rents are way too low.

Someone, I don't remember who,wrote he would not be able to deduct the interest. The buyer can deduct the imputed interest each year as it is 'paid.'

[Naveen Desai]

Hello Yu, I am surprised you are even getting a structured financing deal in Bay area ( assuming that property is in bay area based on your location). If the current owner wants to sell it, they would do it in the open market as the prices are at peak in most parts of bay area at the moment. They may only make a structured deal if it is going to be a lot above FMV.

[Amit M.]

what city is this thing in? You only list Bay Area. If it's in good area it may be worth holding for the appreciation.

[Account Closed]

Yu,

This is how I envision this deal. Based on the price, I believe it is in a "C" class neighborhood in the Bay Area somewhere. Let's break it down.

Your total investment is $80k. You will owe $220k in 15 years. Conservatively speaking and if history is any indication, this property has a decent chance of having a value of $675k in 15 years. Looks like your potential return is $455k on your $80k investment. That's about 570% return on your money. This doesn't include your $600/month cash flow, which I believe you will use towards reserves, maintenance, vacancy, etc.

If you don't need this money, I'd take the bet and put it into the "speculative" investment money of your portfolio. To have your cake and eat it too, this would be a good bet if you can fund it with your SDIRA. The potential return beats the heck out of the stock market. Just my 2 cents.

Good luck.